Head/heels for gold/copper

I don’t know if I’ve been this excited about market analysis since the oil/gold ratio first thwacked me square in the middle of my forehead a few years ago. Every time I seem to more or less pin down one ratio, another ratio that I thought I had more or less secured on a previous occasion begins to feel less certain. This morning, having decided to look back at some of my previous posts to see if they still made sense or were too obviously the product of writing far into the night when I should be fast asleep, I stumbled back onto the conclusion I had made about the gold/copper ratio. This ratio had been causing me trouble recently, because it seemed to be a counterpart to the silver/oil ratio which seemed to be a mirror or indicator of the short term bond yield.

[Edit: After finishing this post, I was unhappy with the formulas I used in the body of the text below, and I redid them as an addendum. The main thrust of the post is unchanged, but the formulas at the bottom express the relationships much better. Sorry for the confusion.]

Although in my most recent posts, I’ve been linking the oil/copper ratio with the dollar index/10-year yield ratio, I had completely forgotten that the gold/copper ratio had been found a much better fit.

Here are some of those charts again. Don’t ask me how, but I just knew you wanted to see them.

gold/copper ratio

dollar/yield (10y) ratio

Now, it is possible that this correlation only holds up during a ‘gold phase’ of our Supersystem. So, I tried to find more data to confirm this, but I was only able to go back to 1995. In any case, here it is.

apologies for not being able to mark the time more clearly!

If you squint just right, I think you will see that since 1995, at least, these two ratios have been strongly correlated. All of the major peaks and dips in the ratio below are reflected in the ratio above, although the magnitudes are not the same.

At first, when I decided this morning that I would make this the subject of today’s post, I was horrified. It just doesn’t seem to make a lot of sense. If gold/copper=dollar/yield, it would seem as if gold were positively correlated with the dollar, which everybody and their grandmother knows is not true. Of course, the equation doesn’t say that, but that is the impression it leaves. For some reason, writing the equation in the following manner is less irritating to me: gold/copper=-dollar/-yield. Mathematically, I think its the same thing, but it somehow seems to preserve the notion that gold and the dollar usually have an inverse relationship. On the other hand, we are still left with the question of why copper and yields should also have this inverse relationship. I had always been under the impression that commodities drove up yields. I would have to go back and look at John Murphy’s classic book to be sure, but I would have said this was a bedrock intermarket principle. Insofar as the yield bucks the trend, it is due to central banks managing interest rates. When rates did not keep pace with commodities rising, this would weaken the dollar and further boost commodities, but over the long haul, I’d have nonetheless argued that rates at least move in roughly the same direction as commodities, no matter what the Fed does.

It would appear that the relationship between copper and yields and between gold and the dollar is more complicated than that (surprise). We have had quite a few occasions in the last couple years where gold and the dollar climbed simultaneously. People have noticed that gold has been holding up very nicely almost irregardless of everything else that is happening in the markets. The economy is slowing down, so people put their money in safe havens like gold, bonds, and the dollar. Or, the unemployment numbers slightly beat expectations. Oh, no! Hyperinflation is on the way. Buy gold! As Bernanke recently said, gold reflects the market’s worry about the possibility of ‘very bad outcomes’–hyperinflation and/or deflation.

But, if this equation,

gold/copper = -dollar/-yields,

is correct, and it seems to be unbelievably tight, then there is nothing unusual about what the market has been up to at any point in the economic cycle. The gold market has been wholly rational.

This is odd from my perspective, however, because my lovely Supersystem says that the Dow/gold ratio should be rising, and when the Dow/gold rises, usually gold does not hold its ground, but it falls rather significantly. Gold obviously is not doing that, but to whatever degree it is defying my Supersystem, it does not seem to be violating intermarket ‘rules’. If anything, the dollar/yield ratio seems to indicate that gold–or gold/copper, at least–should have performed even better than it has.

Before we start fooling around with those questions, however, I’d like to reformulate the equation above to reflect the perspective of individual components of the equation. Just to be clear, these equations are not meant to yield a particular value for the asset or ratio described, but are only meant to reveal price trends. In any case, here they are.

$ = (yield * -gold)/copper

yield = -((-$ * copper)/gold)

copper = (-yield * gold)/-$)

gold = (-$ * copper)/-yield

Also:

gold * -yields = copper * -$

You could try to substitute “bond” for the value “-yield”, which might make some of the formulae easier to contemplate. My math teacher warned me this day would come, and lo, I am not prepared!

Come to think of it, couldn’t I have just said gold/copper = treasury/dollar? Here is the 30 year/dollar:

30 year treasury/dollar index

The 10-year price is somewhat cleaner than this, but it is roughly the same. It has similarly placed peaks and troughs when compared to the gold/copper ratio, but it only appears to work if you subtract the trendline from the price.

It yields simpler equations, at any rate.

gold/copper = bond/dollar

gold * dollar = copper * bond

gold = (bond * copper)/dollar

copper = (gold*dollar)/bond

dollar = (copper * bond)/gold

bond = (gold * dollar)/copper

Much simpler.  Although there is a shift in emphasis that probably makes these simpler equations less reliable.

Either way, if people are piling into safe havens like gold, bonds, and the dollar, you can bet copper is taking it up the kazoo. Of course, these equations by themselves don’t have predictive power. You need to find the driver in order to make predictions. And, a person could argue that those drivers could come from any direction. But, I believe virtually all the circumstantial evidence of the last century points to the monetary system as by far the single most important catalyst in the market. And, that is transmitted primarily through interest rates, especially on the shorter end of the yield curve. We have still not come up with an adequate way to formulate that phenomenon.

This raises the question of the silver/oil=(short end) yields. I had forgotten that the gold/copper ratio is equivalent to the dollar/yield ratio, probably because of the novelty of the silver/oil discovery and my assumption that the gold/copper and silver/oil ratios should have parallel relationships. The gold/copper=dollar/(long) yield equation seems so strong, however–or rather gold/copper=-dollar/-yield?–that I am going to have to look at silver/oil=(short) yields again. It is possible that the two equations are both genuine, but what might that mean?

Let’s try to imagine. Suppose that Japan’s attempt at reflation after the wake of the 1990 bust along with the Fed’s accommodative monetary policy in response to the recession of the same period (both due to the Leeb oil shock caused by Iraq’s invasion of Kuwait) led to the strength of silver prices relative to both oil and gold. These factors also led to the bubble in Southeast Asian assets. These economies (as well as future BRICs) were then squeezed by commodities (I haven’t gotten into the nature of agricultural commodities yet, which developing economies are much more vulnerable to) and the Fed’s tightening from 1994, which marked the top, as I recall, of Southeast Asian stock markets (and an intermediate top in silver ratios), but did not crush the bubble. When the bubble did burst, it took silver down with it. There was a currency crisis and the deflation scare and the Fed was back to pumping money again. And Japan dropped a ton of yen on the US bond market in 2003, which was effectively a rate cut.

Silver/gold recovered here, but silver/oil did not until after the financial crisis and quantitative easing.

This is only the shaky framework of a narrative, however, and doesn’t show us how we could have predicted price action. And, it doesn’t take us to the holy grail of the oil/gold ratio. But, it does appear that extreme movements in the silver ratios (usually) implied Fed rate moves. When silver spiked upwards, tightening was in the cards, and when it dropped, loosening was on the cards. This has not been true on a couple of occasions (only looking back to 1990), when silver spiked upwards and the Fed cut rates instead of raising them. In the late 1990s, the Fed cut rates instead of raising them. (Might this somehow account for the spike in the oil/gold ratio?) And, then again in 2008/2009 (again, financial crisis and deflation fears) and perhaps the first third of this year, when silver–by any measure–exploded, unless you count the Fed’s refusal to extend QEII as a ‘tightening’. At any rate, many other central banks did start to tighten monetary policy. And, no sooner did silver ratios fall than whispers of QEIII began.

Okay, so silver seems to telegraph Fed moves (sort of). What about silver gives it this role, and what is it about oil that keeps the silver/oil ratio in check so that it reflects (sort of) short term yields? When silver indicated that the Fed should tighten during the late 1990s, the Fed loosened, and oil went wild.

I still cannot connect the dots.

[Addendum:

Reading back over those equations with the minus signs was just too brain-jarring. I figured it was best to construct the equations in the following manner, if the simplest manner somehow upset me (or others).

To repeat,

gold/copper = dollar/yield

The apparent correlation between gold and the dollar bothered me, so I thought it might be more palatable to pull a stunt:

gold/copper = (1/yield)/(1/dollar)

But, it doesn’t really add anything at all, except to ‘imply’ that gold is negatively correlated with yields and copper negatively correlated with the dollar, but the equation, of course, does not say that.

So, the equations for the individual components would run as follows:

gold =  (copper * dollar)/yield

copper = (yield * gold)/dollar

dollar = (gold * yield)/ copper

yield = (copper * dollar)/gold

Also,

gold/copper = dollar * bonds

bonds = gold/(copper * dollar)

gold = bonds * copper * dollar

copper = gold/(bonds * dollar)

dollar = gold/(bonds * copper)

Yep, I think that’s what I was driving at.

The gold equation, I think, must strike one as counterintuitive to say the least. All things being equal, gold likes a strong dollar? So it seems. I don’t want to make too much of it, but there is something strange about all of these asset classes ‘liking’ gold but disliking each other.

Apologies again for the confusion.

–ed., July 29, 2011]

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