A train carries iron ore in Australia. Picture: AFP PHOTO/GREG WOOD
A train carries iron ore in Australia. Picture: AFP PHOTO/GREG WOOD

LONDON — Now that’s what you call a rally.

The price of iron ore rocketed 20% on Monday to $62.60 per ton. With year-to-date gains of 46%, it has performed better than any other industrial commodity.

Why? Iron ore often enjoys something of a bounce after the Chinese Lunar New Year as steel mills in the country stock up ahead of the spring construction season.

This seasonal uptick in purchasing activity also often coincides with a slight slowdown in supply, both in China itself and in key origin countries such as Australia.

These "normal" drivers, however, do not really explain the ferocity of the rally.

Rather, the simplest explanation is that iron ore is following steel prices, which have also rocketed in China. Shanghai-traded rebar is up 20% on the start of the year and went limit-up on Monday.

Higher steel prices will incentivise higher production run-rates, implying higher demand for iron ore.

But why have steel prices shot up? That is where things get a bit trickier to explain, at least in terms of traditional fundamental drivers.

But that maybe is the point. Both steel and iron ore are showing every sign of joining the rest of the commodities club, where financial drivers can be just as important as good old supply and demand.

Missing ingredient

If iron ore’s rapid ascent has surprised many commentators, the surge in Chinese steel prices is even more surprising.

Despite much political "noise" from Beijing about supporting China’s flagging economic growth rate and cutting excess steel capacity, there is no clear indication of any short-term turnaround in Chinese steel demand.

Construction remains a net drag while the broader manufacturing sector is also tangibly struggling, witness the continued weakness of both Chinese purchasing managing indices.

It is this missing ingredient that has generated a flurry of warnings from big banks such as Goldman Sachs that the jump in iron ore prices is unsustainable. And from a fundamental perspective, it is hard to disagree with them.

Indeed, the iron ore rally may be a swap of short-term gain for long-term pain, if it encourages the reactivation of higher-cost supply in a chronically over-supplied market.

A similar point could be made for steel. After all, China is already making too much steel and exporting too much steel, stoking trade tensions across the world.

If unmatched by any jump in end-use demand, any extra Chinese steel units are simply going to flow outwards, crushing production rates and prices elsewhere.

A new ingredient

If you’re looking for a fundamental justification for what’s happening to both Chinese steel and iron ore prices, you’re going to struggle. Rather, this is as much about the market itself as about market drivers.

Because without anyone really paying too much attention, trading activity on both the Shanghai Futures Exchange (steel) and the Dalian Exchange (iron ore) has gone stratospheric in recent months.

In Shanghai the change in activity is clearest to see on the hot rolled coil (HRC) contract, which now complements the longer-established rebar contract.

Both volumes and market open interest on HRC have exploded since the start of the (Western) year. Rebar volumes and open interest, meanwhile, are also still growing at a fast pace.

Average daily iron ore volumes on Dalian, meanwhile, grew from 1.95-million lots in the first nine months of 2015 to 2.67-million in the fourth quarter and are now running at 3.48-million tonnes so far this year.

Market open interest has mushroomed over the past six months. It stands at more than 2.1-million lots. This time last year it was just 748,000 lots. There are even signs that Dalian prices are starting to lead spot import prices.

This marks the full coming-of-age of a market where pricing was once set annually in benchmark talks between the world’s biggest iron ore producers and their biggest steel-mill buyers.

That old benchmark system was brought down by the turbulence created by the global financial crisis. The world’s key iron ore suppliers are now largely priced on a quarterly or spot basis. It is that tectonic change in pricing that has spawned thriving iron ore futures markets in both China and Singapore.

But futures markets are available to all, unlike the closed-door benchmark talks of old. And it is quite clear a new breed of Chinese player has joined the iron ore pricing table.

The same phenomenon was seen last year in the base metal contracts traded on the Shanghai Futures Exchange (SHFE).

Volumes in previously shunned contracts such as aluminium and lead have surged. The SHFE’s new nickel contract regularly records volumes in excess of those traded on the long-established London Metal Exchange.

The madness of crowds

Last year will go down as the year in which the Chinese retail investor got interested in industrial commodities.

Powerful, cash rich hedge funds have led the charge, sucking in behind them what might best be described as a retail investment crowd.

Many are day traders. Volume to open interest ratios across the SHFE metals contracts are extremely high by the standards of Western commodity markets such as CME or the LME.

But these new arrivals have found a way of expressing a view on the health or otherwise of the Chinese economy, a view that at times last year was impossible to trade in the stock market after some heavy-handed intervention by Beijing.

Last year that view was bearish. This year it is more bullish, thanks to repeated assurances from China’s leadership that the end of the world is not nigh.

The key point, though, is that sentiment is now as important a driver of iron ore and steel prices as old-fashioned supply and demand considerations.

Or as analysts at Citi put it: "Both markets have become increasingly financialised."

"Price movements in both markets are starting to resemble those of copper, oil, and other financialised commodities with significant influence from macroeconomic factors and financial trading flows in addition to supply and demand."

And surely it is no coincidence that this iron ore rally is taking place while just about every other industrial commodity, particularly oil, has been bouncing off multi-year lows.

It is a sign that iron ore has joined the rest of the commodity casino, a place where the madness of the crowd can sometimes overwhelm fundamentals.

Not for long, though.

That golden rule applies just as much to the new iron ore and steel markets as it does to everything else.

Reuters