As commodities continue to overwhelm financial assets, more attention is being paid to the relationship between prices of fuel and metals, specifically oil and gold. Crude oil is rallying on generous supply and demand forces while gold is shining due to rising global inflation. But as the gold-oil ratio stands at half its 35-year average, a rebound becomes increasingly inevitable, particularly given the current market landscape in interest rates, the dollar and economic growth.
In “From the past, lightly”, five instances are noted in which a bottom in the gold-oil ratio coincided with falling (or negative) yield spreads, a peaking fed funds rate, a falling dollar and eventually falling growth.
Case 1: In the fall of 1979, the gold-oil ratio dropped to 12.5, as gold and oil prices increased in unison, coinciding with a negative 10-year-/two-year T-note yield spread at -70 basis points, a peaking Fed funds rate at 15% and a falling dollar. That market situation accompanied real GDP growth of 2.9% in the third quarter of 1979, before leading to the 1980 recession of -7.8% and
-0.7% GDP growth in the second and third quarters, respectively.
Case 2: In the summer of 1981, the gold-oil ratio dipped to a four-year low of 11.4 amid plummeting gold and stable oil, prevailing along with a –130 basis point yield spread and a 19% Fed funds rate. A 4% decline in the dollar ensued in the subsequent quarter (Q-4, 1981) and recession in the magnitude of a -4.9% and -6.4% growth contraction in Q-4, 1981 and Q-1, 1982, respectively.
Case 3: In November 1985, the gold-oil ratio bottomed at 10.6 during relative stability in both the metal and the fuel, coinciding with a positive, but falling, 10-year-/two-year T-note yield spread at 111 basis points and a peaking Fed funds rate of 8%. The dollar was working through a 10% correction, while GDP growth slowed to 3.1% in Q-4, 1985 from 6.4% the preceding quarter, before bottoming to a 1.6% growth in Q-2, 1986 — the lowest in four years. In this case, GDP avoided a contraction due to the offsetting positive effects of the 1986 oil price collapse following OPEC’s decision to lift production.
Case 4: In November 1990, the gold-oil ratio fell to a five-year low of 10.6, as soaring oil prices reacted to Iraq’s invasion of Kuwait earlier that summer. The 10-year-/two-year T-note yield spread stood at 79 basis points as the decline in two-year yields accelerated beyond the pace of falling 10-year yields, amid the rate-cutting Fed. The dollar had lost 5% since the August invasion and the economy fell in recession with a 3.0% and 2.0% GDP contraction in Q-4, 1990 and Q-1, 1991, respectively.
Case 5: In November 2000, the gold-oil ratio hit a record low of 7.7, reflecting a rally in oil and stable gold prices while the 10-year-/two-year T-note yield spread stood at -16 basis points as the Fed funds rate peaked at 6.50%. In this case, the dollar was on an upward course, going on a two-year rally. But GDP growth did contract in three of the five quarters between Q-3, 2000 and Q-3, 2001 — falling 0.5% in Q-3, 2000 and Q-1, 2001 before shedding 1.4% in Q-3, 2001. Although the contractions were not consecutive, the slowdown fit into the definition of a recession by most economists.
The above dynamics show that a bottoming in the gold-oil ratio has mostly accompanied a peak in short-term interest rates, later followed by rate cuts. The other prominent effect is an economic slowdown. Recessions were triggered in four cases, with the one exception (Q-4, 1985) due to the 1986 oil price collapse. Narrowing yield spreads and a falling dollar were the other key characteristics. In three cases, 10-year yields fell below two-year yields as bond traders priced in a slowing growth environment, dragging long yields below the short end of the curve. The two exceptions occurred in November 1985 and November 1990, when the Fed cut rates. As the central bank tightened, or was expected to, the short end retreated further.
THE CURRENT CASE
As the gold-oil ratio drifts near its record low handle of 7.0 — less than half its 35-year average — a 40% reversal could be in the cards by the end of Q-2, 2006. Assuming oil prices remain around the International Energy Agency’s (IEA) year-end base-line forecast of $65 per barrel, gold would have to rise toward the $650 per ounce level. Oil prices of $60 may seem an underestimate considering the supply-demand dynamics of oil, but it could be argued that these dynamics are preventing prices from heading lower.
Oil prices can push toward $70 and remain there, meaning gold would have to sustain a more aggressive rally for the gold-oil ratio to level out. The fundamentals for higher oil are in place. The IEA revised its forecast for oil consumption to an increase of 1.75 million barrels a day for 2006 to a total of 85.2 million, while cutting its forecast of non-OPEC supply by 335,000 barrels a day to an average of 50.3 million.
Weather related shutdowns in U.S. refineries ahead of the heating season mean that the United States and other importing nations will grow more dependent on OPEC oil. This is highlighted by the drop in worldwide excess production capacity to 30-year lows, leaving Saudi Arabia as the swing producer of spare capacity.
The situation becomes more perilous in light of disruptions and eroding production in Canada, the United Kingdom, Asia and Sudan, which will contribute to next year’s projected production declines. And with geopolitical uncertainties in Iraq, Nigeria and Venezuela, the threat to global crude supplies is further heightened. Combining the above supply uncertainties with escalating demand from Chinese and Indian oil demand, continuously high prices become inevitable.
“SECULAR” GOLD RALLY ON HAND
A logical next step is to consider the prospects of gold doing its part to stabilize the ratio. This year’s gold surge stood out, because along with the 18-year dollar high, gold hit an all-time high in euros at €394 per oz. This so-called “secular” bull market in the metal led to the erosion in the classic inverse relation between the dollar and gold, particularly as the euro sold off across the board in Q-2 and Q-3. But if the euro wilted against the dollar, then why has the dollar struggled against gold? There are two possible answers.
First, rising energy prices around the world have pushed up inflation risks, risking a vote of no confidence in the world’s major central banks and their currencies. As the central banks vie in sustaining economic growth, they encounter the risk of spurring inflation amid rising energy prices. Inflation rates have already exceeded the ceilings mandated by the European Central Bank and the Bank of England, while testing the limits of the Federal Reserve’s tolerance zone. As these institutions appear to be chasing inflation, rather than staying ahead of it, investors become lured to hard assets such as precious metals.
The second possible explanation is the growing instability of the euro, stemming from higher U.S. interest rates, stagnant Euro Zone growth, rejection of the E.U. constitution and a non-promising Grand Coalition in Germany. These factors would normally translate into a rising dollar, pressuring the dollar price of gold. But that gold rallied in both currencies reflects steadfast resilience in the metal. One possibility is the euro’s increased role as a safe-haven currency, sharing the venerable position with the dollar. Thus, when gold rises, traders end up punishing its safe-haven competitor.
DOLLAR, RATES AND GROWTH
Looking at the current dynamics of the dollar, yield spreads and short-term rates — as well as the growth outlook — we can assess the makings of a rebound in the gold-oil ratio, similar to those of the past five scenarios. In each of those cases, a bottoming in the gold-oil ratio was mostly accompanied by a peak in short-term interest rates, which was later followed by rate cuts.
Indeed, futures markets are pricing three more quarter-point rate hikes toward a 4.50% peak. Whether the Fed stops raising before the futures market expects it or not, markets are certain that the peak in interest rates is around the corner. An easing campaign in Q-2, 2006 cannot be ruled out.
The other recurring aspect throughout the five cases of a pickup in the gold-oil ratio was the subsequent slowdown in economic growth. Such a retreat in growth is plausible today amid the Fed’s tightening, combined with higher energy prices and mounting heating bills. The IEA projects an average of a $350 increase (48%) in natural gas for household heating this winter compared to last year, and an average increase of $378 (32%) in heating oil. Those using electricity can expect an average increase of $38 (5%) in their heating bill. Interestingly, U.S. consumers’ contribution to GDP had slowed from 4.1% in Q-3, 2003 to 2.1% in Q-2, 2005 — well before the 30% increase in gasoline prices between July and mid September.
The three consecutive monthly declines in consumer confidence — including a 13-year low in October — suggest a broader deterioration in confidence. Whether the 10-year-/two-year yield spread does invert, it will surely regain its downward path as long as the Fed remains on a tightening course. A GDP growth slowdown should follow in Q-1 and Q-2, with a 60% to 70% chance for a recession in Q-2 and Q-3.
The final piece of the scenario is the course of the dollar. The rise in gold was not accompanied by a falling dollar due to the euro’s decline and gold’s secular rally. In all but one of the five cases, the dollar was on the decline. Today, the dollar’s upward course is expected to begin to fade in late Q-4 when markets obtain better visibility as to when the Fed’s rate hikes come to an end. Thus, although markets are currently pricing a 4.5% Fed funds rate by the end of January, the increased certainty that 4.5% will be the peak should help trigger the unwinding of dollar longs — especially as the Bank of Japan sets to remove its accommodation in Q-1, 2006 and the European Central Bank maintains its inflationary red flags. The dollar rise could even be sharply reversed in the event of a yuan revaluation against the dollar in late Q-4.
The U.S. administration’s insistence to extend the capital gains and dividend tax cuts beyond 2008 and the income tax cuts beyond 2010 may get a fiscal vote of no confidence by the markets, especially as hurricane recovery costs are seen reaching the $200 billion mark.
Finally, the rebalancing in central bank reserves into non-U.S. currencies is expected to continue, especially in light of the anticipated revaluations in Asia. The dollar’s share in global official foreign exchange reserves fell to about 66% at the end of 2004, while the euro’s share rose to more than 25% at end of 2004, from 17.9% in 1999. OPEC also has reduced its dollar-denominated deposits from 75% of total deposits in Q-3, 2001 to 61.5% in Q-3, 2004, while raising the share of euro denominated deposits from 12% to 20% through this same period, according to the Bank for International Settlements.
Reserves rebalancing also has been prevalent on the part of the central banks of East Asia and Eastern Europe. Now that the single currency has lost 11% of its value against the dollar this year, global central banks could well exploit this opportunity to take their profits and scale down their dollar holdings. Thus, the dollar isn’t likely to keep up with gold as the latter attempts to catch up with oil.
Ashraf Laidi is the chief currency analyst at
MG Financial Group, an online currency trading firm. E-mail: firstname.lastname@example.org.