Microcycles and Macrocycles

It seems odd that the oil/copper ratio should correlate or appear to correlate with the yield curve so strongly. It is not so much the fact that oil and copper would be correlated with yields in some fashion, but that the correlation doesn’t run the other way around. I would have guessed that the ‘Leeb oil shocks’ that followed on Klombies’s copper/oil extreme and brought about the collapses in the NASDAQ bubble of the late 1990s and the financial crisis of 2008 would have also been behind the negative yield curves that warned of looming recession.

But that just doesn’t seem to be the case.

Spikes in oil prices appear to be both positively and negatively correlated with the yield curve. More often than not, I would say, it is the yield curve going negative or flattening significantly that indicates an approaching Leeb oil shock. But, to take one example, if you look at 1999-2000 and the oil shock in that case, the situation is somewhat confusing. The yield curve spread dips down to 0.5 or so before oil rockets upwards, but the curve steepens again before flattening and going negative after the oil shock recedes. The Fed tightened rates presumably in response to the explosion in asset prices, including oil. Let’s just say that the situation is confusing and set it aside for the moment. [Edit: There is an error on the chart above. The yield curve in December 2009 did not go to zero. Sorry.]

Last night, I tortured myself about what it was that the silver/oil ratio was saying exactly and why it should appear to be correlated with yields, apparently short term yields, and what the gold/copper ratio was indicating, especially with its huge upward spike beginning in 2006 and stratospheric top in 2009. It occurred to me that this was something of a step forward in my attempt to come up with a commodity cycle model, with the silver/oil balance being determined by bonds. And, there still be a way to salvage that, but what has been of greater interest is the oil/copper ratio and the gold/silver ratio.

And, so I would like to put forward yet another hypothesis. I don’t even know if it’s an hypothesis yet or a half-hypothesis, but it’s something. It has to do with the relationship between secular trends (what I’m going to call “macrocycles”) and cyclical trends (or “microcycles”). As I have pointed out, my Supersystem (I might as well finally dub my system while I am in the mood to make up new words) shows that there has been a freakishly strong relationship between the oil/gold ratio, the year-on-year oil price, the Dow/gold ratio, and the Dow and gold separately. We have great, rolling, unprecedented waves of the Dow/gold ratio since the establishment of the Federal Reserve and the functioning of Leeb’s oil indicator since the “Nixon Shock”. The Dow/gold ratio shifts every 15-20 years or so, while Leeb’s ‘waves’ are separated by 1-10 years.

By using the oil/gold ratio, we have shown that these two phenomena are actually part of a Supersystem and cannot–or rather ought not–be treated separately. I am not going to back into how the Supersystem operates, but I think even if you reject my Supersystem, no one can deny the existence of the secular and the cyclical.

In any case, I’m going to try to tie some of the speculation I have been engaging in and the two central themes of the Supersystem. Leeb’s system (as I have modified it) works on the microcyclical side and is tied to Klombies’s copper/oil ratio, which I am flipping upside down and linking to the yield curve spread.Above this, there is the macrocyclical, the shifts in the Dow/gold ratio, which have grown more and more exaggerated.

My hypothesis is that the manipulation of interest rates has caused macrocycles to become longer and more exaggerated while causing microcycles to become more volatile, intense, and of shorter duration. At the same time, the two cannot be absolutely separated. There is ultimately one market, and I think that the oil/gold ratio in the Supersystem is the link. By itself, the oil/gold ratio looks like a lunatic. It is erratic and superficially has no rationale, but we know (if you accept the Supersystem) that it is wisdom feigning madness.

I mentioned yesterday (I think) that the gold/silver ratio behaves a lot like a yield curve does. It does not resemble the moves of the yield curve the way the oil/copper ratio does, but gold/silver acts as if it were a yield curve, and my suspicion is that it is a yield curve (of sorts), but not for the microcyclical side. Rather the macrocyclical.

Manipulation of interest rates and capital markets by central banks has forced the market to devise a proxy yield curve, just as the market has continued–although unconsciously–to abide by the gold standard. Here is the gold/silver ratio again.

gold/silver ratio vs recessions

Apart from the recessions listed on this chart, you can also see that gold/silver spiked downwards in 1987 and 1997, around the time of the stock market crash and the Asian financial crisis. It has done the same recently, apparently in reaction to the European debt crisis. And, much like the yield curve, it slides upwards again during recovery.

But, standing back somewhat, the ratio does not move with the shorter, cyclical regularity of the oil/copper ratio or the actual yield curve. Although there are different ways to slice it, we can say that the gold/silver ratio bottomed in 1980, peaked in 1990/1991, and then became somewhat more confusing since then.

We know that the gold/silver ratio has reached new lows since this chart was drawn, and I suspect that it is going to fall much lower in the due course of time. But, we cannot ignore the bottom in 1997 and the recovery up until 2003. As I said yesterday, much of the behavior of this ratio since 1990 appears to be linked to Asia, by which I mean Japan. If you recall, the 1997-2003 was dominated by fears of inflation, and it culminated in a Japanese bond buying spree encouraged by the Fed. That seemed to give us the housing bubble, BRICs, an extension on the bond bubble, and the commodity boom.

Since the Leeb oil shock brought all that to an end, the gold/silver ratio has been extremely volatile. It spiked upwards to a decade high and then quickly shot down to a thirty-year low by the spring of this year.

I don’t really mean to commentate on what this ratio is up to at any given time. But, it does strike me that whatever bottom the gold/silver ratio finally attains–assuming that it hasn’t attained it already (eye roll, please!)–the Dow/gold bear market will not end until that gold/silver bottom is found. The market needed a break after the collapse of Japan, but the continued attempts to avert “deflation” since then have brought us violent lurches between booms and busts, inflation and deflation. I think this suggests that the world economy would ultimately be better off if it were allowed to heal, although that would mean pain. If that spike downwards in the gold/silver ratio this year is any indication, we are going to be in a whole lot of pain any way.

To get back to the main point, I am suggesting that there are two economic cycles overlapping and influencing one another. A macrocycle (Dow/gold, gold/silver) and a microcycle (Leeb’s Oil Indicator, oil/copper, yield curve).

Sticking with the theme of commodities and yield curves, if gold/silver is behaving like a yield curve, and so is the oil/copper ratio, then gold and oil are each playing the role of the 10 year note against silver and copper, which are playing short end yields. I would love to see what the copper/silver ratio has been up to for the last forty years, but there is plenty to keep us occupied with the oil/gold ratio. If both oil and gold are commodity proxies for the long end of the yield curve, it is doubly strange that they should have such a volatile relationship, indeed the most volatile of the relationships among the four key commodities.

But, that might also explain why oil/gold is the most important ingredient of the Supersystem. This is where macrocycle and microcycle meet.

Even if anybody can swallow all of this conjecture, the questions of how and why would still need to be answered. I am still not sure about that yet.

If we think back to the question of why the silver/oil ratio should look like short-term yields, as does gold/copper to a lesser extent, it would seem now that the two ratios are odd hybrids of the macro- and microcyclical yield curve proxies. This would suggest that the similarities of silver/oil and gold/copper to yields mean that bonds are also key links in the Supersystem.

Maybe I should take this moment to note that Kevin Klombies appears to be beating a path to the same objective (in a fashion) in his most recent observations. The interesting thing is that he appears to be coming to similar conclusions although he is using a different technique (new highs in commodity prices rather than commodity ratios, for example), and he is linking copper with the 10-year yield, and then oil with the 13-week yield. Which takes us back to the beginning of this convoluted post and the question of how these industrial commodities relate to yields.

If I read Klombies correctly, it is commodities driving interest rates, specifically copper that (assuming it pushes higher) will push up long-term rates which will then push up short-term rates. This brings him to the shocking conclusion that the Fed will raise rates in September! The fascinating thing about this is that–although I didn’t put a time on it–I had struggled with a similar conclusion recently, as well.

Oil/copper and gold/silver both suggest a flattening yield curve is in the works. And, silver/oil appears to intimate a rise in yields, again most likely at the short end. On the other hand, it’s been ‘saying’ that since December 2008, just at the point when they had been slashed to zero–or even since 2004. It is still not clear what the relationship between silver/oil and yields are and which one might lead and in what fashion, so it is possible that these low interest rates are promising a fall in the silver/oil ratio, but I don’t think that’s how it works.

If we try to use the gold/copper ratio, it’s even more confusing. After having peaked early in 2009, it’s been falling fairly consistently, although it did jump briefly again in the spring of last year. We had mentioned before how many of these ratios were, from a technical standpoint, in doubtful territory, so perhaps we should set this discussion aside for now as well.

One thing we have still not dealt with is the transmission of money through the commodity complex from interest rates. I had hoped to get to that in this post, but time and energy do not permit. I will have to close this post out for now and try to pick up those threads again later.


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