Measuring the price of oil against gold offers a valuable perspective on the true value of these commodities as it provides a unique alternative to measuring them solely against the currency in which they are normally priced. The similarity in the trends of gold and oil prices in U.S. dollar terms can leave traders with little indication regarding which commodity commands more secular strength and leads the way in price dynamics.
Just as oil prices are influenced by their own fundamentals — supply decisions by OPEC, inventory data, weather, geopolitics and global growth — gold prices also have their own supply and demand factors: production, central bank purchases/sales, inflation, monetary policy and geopolitics. “Forecasting the fall” illustrates that the relationship between gold and oil since 1972 has remained generally robust. The monthly correlation stood at a solid 78% between 1972 and July 2008.
But more can be gleaned from the close relationship between gold and oil. Since 1972, prolonged declines in the gold/oil ratio have proven to be a drag on the U.S. economy, causing recession in the majority of cases.
The rationale of such causality postulates that oil prices have increased sufficiently relative to gold to the extent of slowing world oil demand and impacting global growth. Thus, in many cases, both gold and oil may be on the rise, but figuring out the pace of increase of one relative to the other is essential in determining the possible implications to economic growth.
During economic expansions, rising demand for industrial metals and energy boosts both oil and gold prices. This leads to a rising or steady gold/oil ratio. In cases where substantial advances in oil are the result of supply factors — political risk, wars, acts of God, labor union action, OPEC action/rhetoric, refinery shutdowns and falling inventories — oil prices tend to chart significant advances, outpacing relative gains in gold and ultimately weighing on the gold/oil ratio.
Ever since the dollar/gold convertibility was suspended in 1973, each of the last five U.S. recessions were preceded by 20% to 30% declines in the gold/oil ratio from recent highs. Although the financial media usually defines a recession as period of two consecutive quarterly declines in gross domestic product (GDP) growth, the U.S. National Bureau of Economic Research (NBER) maintains its recession definition as a “significant decline in economic activity.” The NBER uses indicators such as employment, industrial production, real income and retail and wholesale sales.
Thus, although the recession of 2001-02 did not qualify under the definition of back-to-back quarters of negative GDP growth, it qualified under the NBER’s definition because GDP growth declined in three out of five quarters.
A historical review of the gold/oil ratio and how it has ultimately affected the overall economy can offer some guidance as to how we might trade the markets with respect to this measure.
As the dollar prolonged its decline in the aftermath of the 1973 breakdown of dollar/gold convertibility, oil prices increased four-fold to nearly $12 per barrel in 1974, triggering sharp run ups in U.S. gasoline prices and a subsequent halt in consumer demand.
Gold also pushed higher during the same period, gaining about 15%, but the faster appreciation in fuel dragged down the gold/oil ratio from a high of 34.0 in July 1973 to 23.2 in October of the same year, before extending its fall to 12.2 in January 1974. By 1974-75, the United States and the major industrialized economies had fallen into recession.
The 1973-75 recession was followed by a period of economic recovery lasting from Q2 1975 to Q1 1976 and prevailing over a fall in gold and oil prices. Throughout, the gold/oil ratio dropped from 16.2 to 11.0 as gold fell to a two-year low, losing 20%, while oil remained steady at around $11 per barrel. Although no recession ensued, growth slowed during the second half of 1976.
A tumbling dollar and record oil prices were the main culprits in the 1980-82 recession. The gold/oil ratio dropped from 15.3 in January 1979 to 11.4 in August 1979 due to a doubling in oil to $29 per barrel and a more modest 30% increase in gold.
The 1977-79 dollar crisis was already forcing OPEC to hike prices to offset the eroding value of their oil revenues. But an increasingly unstable political environment in Iran was endangering the fate of oil supplies, resulting in a 200% increase in oil between 1979 and 1980, giving rise to the second oil shock in less than 10 years.
Note the temporary spike in the gold/oil ratio from 12.5 in autumn 1979 to 21 in winter 1980. This was due to a $400 jump in gold from September 1979 to January 1980 resulting from the Soviet Union’s invasion of Afghanistan. The invasion marked a worsening of the Cold War between the United States and the Soviet Union, triggering a run to the safety of gold. Oil prices, meanwhile, posted a more modest 33% increase to $38 per barrel, pushing the ratio higher.
But the gold/oil ratio fell once again from early 1981 to mid 1982 as oil remained around the mid-$30 per barrel level while gold plummeted from the $830s to $400 over the same period as the price impact of the Soviet-Afghan war began to wane. In summer 1981, the gold/oil ratio dipped to a four-year low of 11.4 amid plummeting gold and stable oil, while interest rates stood at a post-war high of 19%, resulting from Paul Volcker’s war on inflation.
Interest rates eventually peaked at 20% in October 1981 before plummeting to 12% in January 1982. The ratio would later make a fresh five-year low of 9.0 in summer 1982, in line with the deepening 1981 recession that extended into mid 1982. The initial declines of the gold/oil ratio between Q2 and Q3 1979, and the renewed tumble in 1980 and 1981, reflected the pullback in gold and industrial metals relative to high energy prices, foretelling the second leg of the 1980s recession.
In autumn 1985, the gold/oil ratio bottomed at 10.6 after declining from a 16.9 high in February 1983 amid relative stability in both the metal and the fuel, coinciding with a peaking fed funds rate of 8%. The dollar was experiencing a 10% correction, while GDP growth slowed in Q4 1985 before bottoming to a four-year low in Q2 1986.
Unlike in the prior cases of falling gold/oil ratios, GDP growth avoided a contraction partly due to the offsetting positive effects of the 1986 oil price collapse following OPEC’s decision to lift production. However, the 35% decline of the gold/oil ratio over the two-year period proved a successful signal to the 1985-86 slowdown and the resulting Fed rate cuts during February though July 1986. The war, the slowdown and the rate cuts prolonged the fall of the U.S. dollar, which was initiated by the joint interventions between the United States and major industrialized countries.
Upon Iraq’s fateful invasion of Kuwait on Aug. 2, 1990, oil prices surged from less than $21 per barrel to $31 per barrel in less than two weeks, before extending to a then-record $40 per barrel in October. The oil price jump dragged the gold/oil ratio by 50% to a five-year low of 10.6 in less than three months.
That autumn, the Fed accelerated its interest rate cutting campaign, slashing rates from 8% in August to 7.25% in December before pushing them down to 3% into autumn 1992. The recession would last from the fall of 1990 until the end of Q1 1991.
The currency impact was largely negative for the dollar in the eight weeks following the invasion as escalating oil prices hampered a U.S. economy still reeling from the banking failures of the savings and loans crisis of the late 1980s. Soaring oil prices of summer 1990 exacerbated the slowdown and pushed the economy into recession from Q3 1990 to Q2 1991.
In December 1998, oil prices plummeted due to OPEC’s decision to increase supplies combined with the break of Asian oil demand amid the 1997-98 market crisis. OPEC’s miscalculation cut oil prices by more than half to $11 per barrel in December 1998, their lowest since the glut of 1986. But the combination of cheap oil and rising investment spending fed into a powerful rally in asset prices (stocks and real estate), thus resurrecting global appetite for fuel throughout 1999 and 2000. Oil prices more than doubled in 1999, breaching the $37 mark in 2000, the highest since Iraq’s invasion of Kuwait 10 years earlier.
The effect of higher oil and rising interest rates from Q2 1999 to Q2 2000 would transition from that of an economic cooling to a prolonged stock market sell-off lasting three long years. The 10-year economic expansion was declared officially over in March 2001 by the NBER. Once again, the recession was predicted by the gold/oil ratio’s tumble to a nine-year low of 11.1 in 1999.
Despite the 2001-02 recession and the prolonged bear market in equities, the dollar maintained a predominantly strong run, with the exception of a relatively brief retreat from late November 2000 to mid-January 2001. The dollar index had fallen more than 8% as markets anticipated a looming rate cut. The dollar decline proved limited as traders rewarded the currency due to the Federal Reserve’s aggressive easing, which was seen as a means for the U.S. economy to lead the world economy into recovery mode.
After the outbreak of the second Iraq War in March 2003, oil prices began their multi-year bull market, rising from $30 per barrel in March 2003 to more than $50 per barrel in March 2005. Oil would end the year at $61 per barrel, up more than 100% over the prior two years compared to a 54% increase for gold over the same period.
The oil price moves dragged the gold/oil ratio to 6.7 in August 2005, its lowest level over the past 35-year history. The global economic expansion had broadened into emerging markets, and China had displaced Japan as the world’s biggest oil consumer behind the United States. China’s demand was also notable in heavy industry commodities, especially in copper and gold.
As the gold/oil ratio fell by nearly 50%, the negative implications of its decline began to surface in the U.S. economy. By the time more stable oil prices and faster gold appreciation in Q1 2006 lifted the ratio off its lows above the 10 level, U.S. GDP growth fell from 4.8% in Q1 2006 to 2.4%, 1.1% and 0.6% for the following three quarters of the year.
The slowdown turned into a prolonged economic and market erosion, forcing the Fed to slash rates by 325 basis points between September 2007 and April 2008 as well as to back an historic rescue of Bear Stearns. Renewed dollar damage pushed gold higher, lifting the gold/oil ratio to as high as 11.0 in early 2007. After that, the ratio would start a fresh decline as the effect of corroding oil supplies was compounded by rising demand from Asia. The falling dollar would also fuel the climb in crude oil, which ultimately hit $145 per barrel and allowed for an all-time low of 6.5 in the gold/oil ratio.
The most cogent conclusion to be drawn from the above analysis is that a bottoming in the gold/oil ratio has mostly accompanied a peak in short-term interest rates, slowing economic activity and ultimately interest rate cuts. Recessions were triggered in four out of the five cases, with the exception of the third scenario (Q4 1985) due to the positive growth implications of the 1986 oil price collapse. The ratio has proven to be a better indicator of financial markets, including currency trends, than many individual series and illustrates the importance of relative data.
The 2005 low had already signaled a break in economic activity, while the current all-time low of 6.5 is pointing to heightened recession risks in the United States and
overseas, potentially in the United Kingdom. For traders, the lesson here is clear. While significant, individual commodities are often more useful when viewed relative to related markets and not just the currency they are priced in. Rather than simply focus on the price of oil and gold separately, traders ought to follow the interaction of these two important commodities.
Ashraf Laidi is chief FX strategist at CMC Markets and author of “Currency Trading and Intermarket Analysis: How to Profit from the Shifting Currents in Global Markets” (Wiley Trading).