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(Repeats earlier story for wider readership with no change to text. The opinions expressed here are those of the author, a columnist for Reuters.)
By Clyde Russell
LAUNCESTON, Australia, April 18 (Reuters) - In the first two months of the year, China's steel and iron ore prices were surging because output was growing strongly, but now they are falling for exactly the same reason.
Perhaps it's just proof that eventually you can have too much of a good thing, or more likely, another example of how investors try to shape the market narrative to suit what they want to happen.
In this case, increasing steel output at the start of 2017 was viewed as proof of the strength of the Chinese economy and optimism that infrastructure spending and construction were going to keep demand robust.
But that market sentiment started to shift toward the end of March as investors finally started to focus on the strong buildup of both steel and iron ore inventories.
The increasingly bearish view received a huge boost with Monday's news that steel output climbed to a record 72 million tonnes in March, exceeding the prior record of 70.65 million from March 2015.
China, which produces about half of the world's steel, produced 201.1 million tonnes in the first quarter of 2017, up 4.6 percent from the same period last year, according to data from the National Bureau of Statistics.
The strong steel production in the January-March period does help explain why imports of iron ore were also gaining, and does go some way to explain the sharp increase in prices.
The price of spot iron ore in China .IO62-CNO=MB rose 20.3 percent from the end of last year to the peak so far this year of $94.86 a tonne on Feb. 21.
Since then the price has been steadily retreating, but the pullback has accelerated sharply in the recent weeks, with the price slumping to $66.25 a tonne on Monday, down from $81.54 as recently as April 5.
The drop in iron ore has been mirrored in steel rebar contracts traded on the Shanghai Futures Exchange, which ended on Monday at 2,932 yuan ($426) a tonne, down 13.2 percent from their closing peak this year of 3,377 yuan on March 15.
While there is little doubt that steel and iron ore prices ran too hard, too fast at the start of this year, the question remains as to whether the fundamental supply-demand outlook has changed so dramatically in the last few weeks as to change the entire market dynamic?
The answer is probably no, but what does appear to be happening is that investors are finally returning to a more realistic appraisal of the Chinese economy and its prospects for this year.
Growth was stronger than expected in the first quarter at 6.9 percent, beating the consensus for a 6.8 percent gain, but there are some concerns about the resilience of property and infrastructure construction.
This alone should lead to some caution on the steel sector, and while March's output of 72 million tonnes is likely to be the high water mark for now, there is little reason to believe that steel production is on the verge of a major pullback.
Already there are signs that the elevated inventory levels are starting to ease, with rebar stocks SH-TOT-RBARINV monitored by industry consultants SteelHome dropping to 6.23 million tonnes in the week to April 14, from a recent peak of 8.4 million on Feb. 17.
While rebar inventories are cyclical, tending to build in winter and be drawn down in summer, there is still room for further declines before a lack of stocks will provide price support.
Iron ore inventories at Chinese ports SH-TOT-IRONINV have also softened somewhat in recent weeks, but are still at historically high levels.
Stockpiles declined to 130.4 million tonnes in the week to April 14, down from the record 132.5 million from March 24, but still well above the 2016 low of 79.4 million from June of that year.
More so than steel, iron ore inventories have some way to drop before there would be pressure to rebuild, meaning the iron ore price probably has more downside potential than that for steel.
Editing by Christian Schmollinger