Over the past few years, the relationship between gold and silver has expanded to include a large number of additional financial instruments, among them eurodollars and the U.S. dollar index. These additional markets expand this partnership into new territory and offer several new angles for analyzing the direction of prices.
“The Partners” shows December 2009 gold and silver futures prices, eurodollar rates and the U.S. dollar index from March 2 through July 8, 2009. These charts indicate that the junior partners of eurodollars and the dollar index do not always agree with their precious metals elders. From the middle of April to the first of June, there is almost total disagreement as gold and silver prices climbed, while eurodollar rates and the dollar index declined.
Eurodollar rates and the dollar index would certainly protest their description as a negative influence in the relationship because a decline in either usually accompanies increases in gold and silver prices. Lower interest rates, represented by falling eurodollar rates, allow gold and silver to be held with lower storage costs. A falling dollar value tends to lift all commodities and make gold and silver relatively more expensive. Thus, the charts for eurodollar rates and the U.S. dollar index indicate support for gold and silver. From June 2 to July 8, the dollar index was low and stable, while December eurodollar futures showed low rates at the beginning and end of the period.
BETWEEN THE METALS
Between the senior partners of this ancient relationship, there is some disagreement as to the balance of power. Through the centuries, the ratio of value between gold and silver has varied and as “Ratio of gold to silver” shows, the comparative value of gold to silver increased from 68.6 to 74.5 from March 2 through April 30, 2009, then the ratio declined to 66.5 by the middle of June. Reasons for the decline in the gold-to-silver price ratio include the larger volatility of the price of silver relative to gold and the extra boost given to silver by the decline in interest rates. From June 2 to July 8, gold returned to the level of 70 times silver as both metals fell in price while the higher volatility of silver carried it down relative to gold.
Although the price of gold holds an advantage of approximately 70 times the price of silver, the two partners show a high degree of correlation in their variations over time. “Precious correlation” contains a short-term history of their relationship, from March 5 through July 8, 2009.
The short-term comparison of gold and silver combines two averaging processes to enable the resulting data to vary around the standard ratio of 1.00. Original prices are averaged over 90 days from March 2 through July 8. Each day’s price is computed as a ratio to the 90-day average. To eliminate minor variations, the first ratio is divided by a four-day moving average of ratios to the 90-day average. The final results are referred to as “ratios to moving average.”
The variations of silver and gold indicate that silver is more volatile than gold, with ratios to moving average that reach higher peaks and fall to lower troughs than those of gold. Only one gold ratio rises above 1.02, compared to nine for silver. None of the gold ratios fall below 0.96, compared to four for silver. Along with its higher volatility, silver is still a long-term partner, with ratios to moving average that consistently return to the standard of 1.00 and pass by gold on the way to the other short-term extreme.
Comparative volatilities of gold and silver may be measured by an option pricing method such as the LLP model or Black-Scholes. On July 8, 2009, the LLP method computed the heights of December 2009 call price curves for gold and silver as percentages of the current futures price. For gold, this volatility measure was 5.88%, while silver was higher at 8.66%.
According to the LLP model, the market consensus of the possible price spreads at expiration in December 2009 is $1,020 to $808 for gold and $15.25 to $10.70 for silver. The price spreads equal 23% of the current futures price for gold vs. 35% for silver. The volatility measures confirm that silver will continue to vary more strongly than gold, while the two remain committed to their historical partnership.
SILVER & EURODOLLARS
When we look at the relationship between silver and eurodollar rates, we find that the short-term interest rates have the greater volatility. “Inverse relationship” shows silver and eurodollar rates as ratios to their moving averages in the smoothing process explained above. In this comparison, the majority of higher peaks and lower troughs are held by eurodollar rates.
“Inverse relationship” shows a negative correlation between silver and interest rates. When interest rates peak, we generally see the silver ratio going down, while downward moves in rates accompany short-term peaks in silver ratios.
The strong effect of interest rates on the price of silver, together with the decline in eurodollar rates from mid-April to the first of June 2009, indicates that the gold-to-silver price ratio is influenced during this period by the decline in interest rates. As shown by eurodollar December futures, declining rates helped to increase gold and silver prices, but the drop in the gold-to-silver price ratio showed that interest rates had a significantly stronger impact on silver than on gold.
THE INVERSE INDEX
The junior partner that seems to be receiving good press, while not having to do much work is the U.S. dollar index. When the dollar index is lower, gold is higher. It is apparent that gold has higher volatility, with generally higher peaks and lower troughs than those of the dollar index. However, silver vs. the dollar index shows more volatility of silver around the quieter broad gauge of the U.S. dollar. The silver ratio consistently extends above 1.02 and even rises above 1.04 and 1.06, while the dollar index ratio is confined below 1.01.
The cause-and-effect sequence is probably this:
1. U.S. Treasury and Federal Reserve policy decisions combine responses to the recent financial crisis and domestic economic problems and favor a reduction in short-term interest rates.
2. Falling short-term rates help to lower the value of the dollar index.
3. Declining rates tend to increase the prices of silver and gold, with the stronger influence being between interest rates and silver.
4. Silver and gold increase in price, with silver gaining in terms of the gold-to-silver ratio during periods in which it receives additional momentum from falling interest rates.
Large positive variations in the ratios to moving average would seem to indicate a reverse movement in the futures prices of silver. However, the effect is often in the opposite direction, with a large positive variation from the standard ratio of 1.00 resulting in a short-term continued upward movement in the futures price. The momentum is up, not down. Examples based on price and moving average data illustrate possible gains.
“Cashing in” shows results from the six ratios from moving average that exceed 1.02 on at least two days in sequence. This may be an unusually productive sample; however, the concept is worth pursuing in this mix of gold, silver, eurodollar rates and dollar index. Relatively high ratios to moving averages may be considered indicators of momentum for the futures price.
It should be expected that as interest rates increase with renewed economic growth and potential inflation caused by massive government bailouts and investments, the relative value of silver will decline vs. the price of gold. The process described here — computing ratios to moving average price movements in the four-way partnership — should continue to be a useful method for assessing potential risk and return in gold and silver futures as they relate the both eurodollars and the
currency market.
Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.
