Joe Hockey has taken some recent stick for his mid-year economic update, in which he oversaw a dramatic lowering of the economic assumptions that underpin the government’s revenue and cost assumptions. To the sceptics, the Treasurer is setting up an easy win for the new government as the economy outperforms Treasury’s conservative estimates and delivers a quicker-than-forecast surplus, about which Hockey can crow.

But there is one key assumption in the Treasury’s outlook that might not be bearish enough. It is the price of Australia’s key export commodity — iron ore — which is shaping up to have a very difficult 2014.

For several years now, iron ore analysts have been expecting significant falls in the iron ore market. That correction has been underway since the iron ore price peaked in late 2011, and the average price of has fallen every year since.

But the story so far has been how slow and manageable that decline has been. Even if it’s been enough to kill off some of the more extravagant expansion plans in the Pilbara, it’s been death by a thousand cuts, not by the guillotine.

One could be forgiven for hoping that that would continue. After all, China’s demand for iron ore seems insatiable. Every time its hunger wanes there’s a new burst of construction activity that sucks in ever more red dirt, and the volumes shipped to China will quite likely double from 300 million tonnes in 2008 to 600 million tonnes in 2014.

Last year was a case in point. Following a dizzying price plunge in late 2012 to $87 from $140 — and a life-threatening few months for Fortescue Metals Group — iron ore soared again as China’s appetite renewed on a mini-stimulus package that pushed its growth rate back above 8% and gifted iron ore an average price of $135 for the year.

This year, however, signs are emerging that the iron ore market is weakening swiftly again, and there are reasons to think that any snapback will not be as generous.

The iron ore market operates on three concurrent cycles. The first is China’s business cycle and whether or not it is improving and/or changing. In the past, strong growth in China has been directly correlated to strong iron ore imports and because it consumes over 60% of seaborne ore.

And China is slowing. The People’s Bank of China is tightening credit, especially around its shadow banking system, in an effort to prevent it from running too far out of control. As well, the fiscal stimulus of last year is running out of steam and the pipeline of projects is winding down. These two measures are a part of what has generally been described as China’s “rebalancing”: its move to consumer-led growth rather than investment-led growth. It is likely China will slow to, and perhaps below, 7% growth this year, and the shift in its growth composition will accelerate as well, both of which will weigh on iron ore.

The second cycle at work in the iron ore market is the balance of supply and demand. For many years, iron ore has been in terribly short supply, but that is changing fast. This year, UBS and Goldman Sachs both see an iron ore surplus approaching 100 million tonnes (in a total seaborne market of 1 billion tonnes). It doubles the year after, most of it coming from the Pilbara. Goldman is especially bearish, expecting an iron ore price averaging $110 this year and $80 next year.

There are arguments to offset notions of a price fall. Expensive Chinese iron ore production is expected to cease as cheaper Australian supply emerges, and the concentration of ownership in the Pilbara cartel helps as well. But the sheer scale of oversupply, and the sunk costs that have produced it, mean the production must be shipped — so a shakeout in the iron ore price is unlikely to be either smooth or rational.

The third cycle at work in iron ore markets is that which surrounds Chinese steel mills. At various times China itself stocks very large iron ore inventories at steel mills and at its ports. Sometimes this is because of seasonal factors like the Pilbara cyclone season. It has also been a pretty clear case of hoarding by speculators cashing in on the shortage in the past as well. The final and major factor is that Chinese steel mills use their purchases of iron ore (and coking coal) as a way of enhancing their profitability and balancing their books as steel prices wax and wane.

It is this last influence over Chinese iron ore stocks that is most important (and concerning) today. Even as demand growth for iron ore is slowing along with China’s rebalancing act, Chinese steel mills and ports are brimming with iron ore supplies. Credit Suisse provides a chart that shows how many days stock that mills currently possess:

Port stocks too are higher than they have been in well over a year:

Typically, Chinese steel mills undertake inventory destocks of iron ore when the profitability of steel falls and they need extra cash. As China slows and steel prices remain very weak, that is exactly where the mills are today.

In each of 2011, 2012, and 2013 iron ore experienced a Chinese destocking event, and each time the iron ore price fell the better part of $50. Today’s price is $120, so if it were to happen now that would lead to undreamed-of lows for Australia’s number one export commodity much faster than anyone is expecting.

Of course, each time that has happened in the past the price has subsequently recovered a few months later. This time, though, the balance of supply is shifting against the miners as well. Any rebound will be hitting a wall of supply and will not be as sharp, as high or as enduring.

All of this is quite uncertain. One can only point at the current combination of factors at work in the Chinese steel market and note that they are precisely those that have triggered big iron ore destock cycles in the past. But it’s a fair conclusion to draw that at some point this year Australia will endure a renewed terms of trade (ToT) shock.

The Treasury assumed that the 2013-14 budget year would record a 5% fall in the ToT and 5% again in 2014-15. Iron ore makes up roughly one-third of the terms of trade, so each three dollar fall wipes off approximately 1%, with the hit dispersed by the quarterly contract system that still governs much of the market. From an average price of $135 last year, a fall to $100 in iron ore in 2014 for any period of time would put the terms of trade falls materially ahead of Treasury’s forecasts, resulting in lower national income, lower nominal growth and much lower corporate profits than projected.

Australian rebalancing has farther to run, too.