Iron Ore Prices and the Clamor for Liquidity

Is more liquidity really what's needed...?

MORE LIQUIDITY will stop everything from sinking. Got that? That's the logic behind what everyone now expects will be more quantitative easing (money printing) from the US Federal Reserve, writes Dan Denning at the Daily Reckoning Australia.

But can the money printers of the world really fix a solvency problem with more liquidity?

Let's shove that question aside for just a moment and return to the urgent matter of the plummeting iron ore price. When last spotted, the spot iron ore price was busy falling below US$90. It's over 50% down from around this time last year. Many interested parties want to know how much further it will fall, or when it will rebound.

BHP Billiton and Rio Tinto are probably not that worried about the reversion to mean in iron ore prices. Both companies control high grade ore deposits AND the infrastructure to deliver ore to Port Headland for export to China. Low-cost producers with high ore grades can stand further price falls...all the way down to around $40 in fact.

But marginal producers with lower quality ore and higher costs are sweating it now. Gina Rinehart's $9.5 billion Roy Hill project needs $7 billion in financing, for example. And poor old Twiggy Forrest and Fortescue Metals Group CEO Nev Power are even considering selling off some assets to fund the North Star magnetite project. Meanwhile Moody's is reviewing Fortescue's credit rating.

You'd think Chinese iron ore producers would be hit the hardest by falling spot prices. Chinese ore grades are lower than the ore from the Pilbara. And with Chinese steel output falling (and Chinese manufacturing activity in contraction for the first time in nine months) you have yet another factor leading to lower ore prices in the spot market.

Now all things being equal, lower prices should force marginal producers to shut down capacity or even go out of business (assuming they can't raise money in the debt markets to keep going). Eventually, if you take enough supply off the market, what's left will more evenly match demand. Prices will stabilize. The freak out will be over.

In the meantime, the freak out is spreading. By 'freak out', we mean people who were counting on the iron ore price to stay high in order to deliver associated benefits. For example, Western Australia Premier Colin Barnett reckons falling iron ore prices will wipe out $1.5 billion in royalty revenue from the State budget. That's real money.

Australia's federal government is probably freaking out as well. The mining tax — remember it was on iron ore and coal, the two commodities falling most in price in the last six months — was supposed to deliver a small budget surplus of around $1.5 billion this year. If the tax fails to deliver the cash, more spending cuts will be required to keep the budget in surplus.

If the budget isn't in surplus, it has to be in deficit. And a budget deficit is not the kind of fiscal factor you'd expect to be bullish for assets denominated in Australian Dollars, including the Australian Dollar itself. In other words, if the iron ore price doesn't find the floor, it could lead to money leaving Australia and a correction in the value of the Australian Dollar.

One man who is not freaking out is Reserve Bank of Australia Governor Glenn Stevens. He was asked in Canberra last week if the Australian Dollar would remain a safe haven even as commodity prices fell. 

'It is conceivable that you could get terms of trade falling but there is some event that causes safe-haven flow towards us...I do not actually think that will happen. You can imagine it, but most likely if the terms of trade fall a lot, then the currency will go down, I think,' he said.

A falling currency would save the RBA the trouble of cutting interest rates. Exports might pick up as Australian goods become cheaper globally. And if China's manufacturing blues are bad news for base metals and bulk commodities producers, they are good news for gold, silver, and palladium. The whole precious metals complex (in both Aussie and US Dollars) is moving on up in expectation of a paper money infusion from the Fed.

Which brings us back to the Fed. Does Ben Bernanke really believe long-term asset purchases eventually lead to higher employment and economic growth? He must, or he's a very good liar. As far as we can tell, Wall Street investment banks benefit the most from QE because they can borrow from the Fed, buy government bonds and capture the spread.

The only other interest group on the planet that's a clear winner from QE is the United States government. It's been able to grow total US debt from $10.6 trillion in 2008 to $15.9 trillion today — and pay lower rates to borrow the whole time! Yet unemployment in the US is higher than it was four years ago and median incomes are lower.

Just who exactly is Bernanke still fooling?

But maybe the alternative appears worse to the Fed heads. The alternative is that assets prices will fall much further if liquidity disappears from the system. The system is the Fed's system. It's the Dollar system. And the Fed must reckon survival is better than death. For the rest of us, we're not so sure.

Time to Buy Gold?...