Commodities

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Picture Donald Trump being elected president and then getting hit by a meteor just as he began his inauguration speech. That is about as likely as a 19 percent one-day jump in the price of iron ore. 

And yet, here we are.

Based on Bloomberg data going back to May 2008, Monday's move in the price of iron ore delivered to Qingdao in China has happened precisely once out of 1,790 trading days. It is what statisticians would call a 10-sigma event -- or, somewhat less accurately but much more prosaically, something that never happens.

This isn't to say that iron ore prices are particularly stable -- far from it:

Shock and Ore
Spot price of iron ore with 62 percent ferrous content delivered to Qingdao, China
Source: Bloomberg

Clearly, with the market having bungee-jumped from about $140 a tonne to $40 over the course of 2014 and 2015, the chances of a snap back are pretty high: Monday's move takes the gain so far this year to 46 percent. Having moved in one direction for so long, and with iron ore lacking the liquidity of, say, copper or aluminum, it's a pretty sure bet that short sellers scrambling to cover their positions explain at least some of Monday's mania.

There is some underlying rationale to the bounce, though. As Kenneth Hoffman of Bloomberg Intelligence noted in a new report, Chinese demand for steel, of which iron ore is a critical ingredient, is typically strong after the country's new-year celebrations are over. This year, that has helped margins on Chinese steel turn positive again, Hoffman pointed out:

Back to Black
Bloomberg China Steel Profitability Index
Source: Bloomberg Intelligence

China injected a further dose of optimism over the weekend, revealing at the start of the annual National People's Congress that growth has once again trumped reform in terms of Beijing's economic priorities.

And here is where the too-good-to-be-true aspect of iron ore's rally reasserts itself.

First, take another look at that chart of Chinese steel margins again, but this time over a longer period:

Heavy Metal Revival?
Bloomberg China Steel Profitability Index
Source: Bloomberg Intelligence

Last year was plainly one to forget in the Chinese steel industry; the question is whether it will be able to. On the demand side, some point to the recent jump in property prices in China's most prominent cities, stoking expectations of more construction and thereby more consumption of steel and, by extension, iron ore.

The problem with this argument is that while things look rosy in real estate in China's so-called Tier 1 cities, the vast majority of property sales occur in those cities further down the pecking order -- and things are a lot less bullish there:

Fears For Tiers
Price of new residential buildings in Chinese city groups, year-over-year change
Source: Bloomberg Intelligence

Chinese property prices, to which the fate of iron ore is inextricably linked, get to the heart of why relying on Beijing's stimulus efforts to carry the market is ultimately a bad idea.

China is burdened by excess: too much industrial capacity, too much floor-space, and too much debt. In a report published in August, the International Monetary Fund compared China's building frenzy to other countries similarly enamored with construction. This isn't a ranking you want to be at the top of:

Space Mountain
Peak residential construction investment as a share of GDP by country and year
Source: International Monetary Fund
Note: Figure for China is residential real estate investment

Chris Watling, who runs London-based research firm Longview Economics, sets this in a wider context:

China has most, although not all, of the usual structural macro flaws that precede a credit bust and emerging market crisis. Its debt has risen by more than 100 percentage points of GDP in 6 years...its banking system has grown over 10 fold in 10 years and is now considerably larger than the real economy; while construction has played a dominant part in the recent growth miracle.

The Chinese government has been pushing a reform agenda, on and off, precisely in order to wean the economy from its fixation with construction and heavy industry toward consumption and services. The latest plan lurches back toward growth -- albeit, notably, at a slightly slower pace than previous targets -- with an explicit commitment to do so with more debt.

From a commodity trader's perspective, stimulus is stimulus, so a rally is justified -- regardless of whether or not it is storing up more trouble for the Chinese economy as the return on each new buck of debt generates less bang (something I wrote about with regards to the oil market here).

The added twist for iron ore, though, is that even as Beijing shifts back to a growth posture, it still aims to lay off 1.8 million steel and coal workers -- part of an effort to address the chronic overcapacity destroying margins in those industries and escalating trade tensions due to excess supply being dumped overseas.

So the bull case for iron ore rests largely on a Chinese government commitment in the face of slowing growth to juice things with more debt while simultaneously restoring balance in the steel market by cutting capacity. That could support a sustained rally; anything's possible. It just doesn't seem likely.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net