BAML: Steel yourself for further Australian dollar weakness

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Steel prices provide the best metric of China’s underlying demand for Australia’s key commodity exports, and therefore may be more influential on movements in the Australian dollar than those in iron ore and coal.

That’s the view presented by Adarsh Sinha, head of Asia Pacific G10 Foreign Exchange Strategy at Bank of America Merrill Lynch, who suggests that Chinese steel prices are a more reliable guide to likely movements in the Australian dollar given they tend to be far more stable and less influenced by inventory swings compared to iron ore.

Whether a coincidence or indeed an underlying driver of movements in the Aussie, Sinha’s call appears to have legs, at least in recent times.

He points out that since the PBOC decided to adopt a more market-orientated fixing mechanism from the Chinese renminbi (RMB) on August 11, something that saw the RMB weaken sharply in the days following the announcement, Chinese steel prices have fallen 4.3%, a move similar to the 4.7% decline seen in the AUD/USD. In comparison, the spot price for benchmark 62% grade iron ore is largely unchanged over the same period.

While Sinha predicts that Chinese steel prices are likely to stabilise if not rise in the latter parts of the year, something that may underpin the Australian dollar given the correlation between the two, he, like others, believes there’s further weakness for the Aussie ahead.

“Our assessment of steel price dynamics suggests it is likely to stabilise if not rise heading into year-end, and is a key reason we are comfortable with projecting only a small further decline in AUD/USD (to 0.69) by December,” says Sinha.

“We continue to expect it to reach 0.65 in 2016 as capital inflows into Australia’s resource sector decline.”

Previously Sinha saw the Australian dollar finishing 2015 at 71 cents, and 68 cents by the end of 2016.

He believes the fundamental “big picture” remains negative for the AUD, and suggests that the exchange rate needs to move further below “fair value” if it is to provide any degree of support to the economy.

Sinha believes that downside risks to his forecasts stem from the RBA cutting interest rates further, something that would put further downward pressure on the AUD than he currently anticipates. On the upside, he suggests a lift in steel prices as a result of increased stimulus spending in China could scupper his call should it eventuate.

Currently the AUD/USD trades at .7060.

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