The Copper-Gold Conundrum

By Richard Baker       Sep 6 2011 12:15PM eurekaminer.blogspot.com

In late July bullish conditions re-emerged for both copper and gold for the second-half of this year. Gold set new records in August but copper and other base metals fell into retreat as storm clouds gathered over the Western economies and worries about Chinese growth persisted. Presently, the gold:copper ratio sits at recession levels – harbinger of worse things to come or just a bump in the recovery trail?

The copper-gold conundrum

“How many pounds of copper buy an ounce of gold?” is a good market question to ask for several reasons. Copper has been a reliable proxy for global growth given its broad industrial use and comparing copper to gold results in a valuation isolated from the influence of today’s vacillating fiat currencies.

My July 28th Kitco Commentary looked at the relation of copper and gold from four viewpoints and the future for both metals appeared quite promising. The analysis covered a period from last September through July 22. The table below summarizes three of those factors then and now - updated to Friday’s market close:

The fourth factor was related to fundamentals. In late July, copper was being driven by supply and demand and less by investment flows as in the frothy days earlier this year. A “risk-off” investor sentiment surfaced and became virulent in August.

How such a dramatic turn of fate could occur over such a brief period of time is the essence of the copper-gold conundrum. A look at the pieces may shed light on this commodity riddle.

The Au:Cu ratio surges in August

Here is an updated one-year chart of the gold:copper (Au:Cu) ratio from Sept. 2, 2010 through Friday:

My July 28th Kitco commentary noted that the ratio (magenta line) was near a historical midpoint (bold dashed line) on July 22 trading at 363 pounds of copper per troy ounce of gold.  This was the same level seen in late November when key commodities enjoyed a roughly six-week period of normalcy and stability before the Federal Reserve’s second round of quantitative easing and other factors inflated commodity prices into the spring of this year.

At those two dates,  the ratio approached the three-month moving average (solid black line) suggesting copper prices were responding to supply/demand fundamentals and less to speculation as in the notable departure between the ratio and average when COMEX copper scored a frenzied peak price of $4.6375/lb on Feb. 7.

The dashed ellipse indicates what happened from that commentary to the present. By the morning of Aug. 22, it took 100 pounds more of the red metal to buy an ounce of gold. As gold prices soared and copper futures fell below the key $4/lb-level, the Au:Cu ratio peaked above 470 lb/oz. COMEX gold scored a new nominal price record of $1,917.90/oz the following day. Although gold corrected and then rebounded, the Au:Cu ratio was only slightly lower than its peak this Friday closing at 455 lb/oz.

There are three troubling aspects to this development: 1) an Au:Cu ratio above 400 is reminiscent of levels seen during the 2008-2009 financial crisis, 2) if the peak were due to a speculative bubble bursting in gold prices, there would be a rapid convergence to the average which hasn’t occurred and, 3) the Au:Cu ratio stability is markedly divergent.

On point three, commodity ratio stability is defined as the three-month standard deviation divided by its mean. During last November and this July, the stability measure was less than 3% or “very stable.” That measure hit a 52-week high this Friday at 9.8% - a very “divergent” state. This is not solely a copper-gold phenomenon. The gold-referenced ratio for NYMEX WTI crude oil, arguably a metric for U.S. domestic recovery, made its 52-week divergent high on the same day at an alarming 13.2%.

The  Au:Cu correlation trajectory turns very bearish

Commodity ratios diverge when the price of a commodity moves in an opposite direction from its reference – in this case, copper compared to gold. The two thus become negatively correlated over time and if the trend persists the commodities are said to be “inverted” when the one-month and the three-month correlations are both negative. This is a very bearish condition (ref: July 28th Kitco commentary).

Here is a plot of the three month versus the one month Au:Cu correlations with the same date milestones as the previous chart:

During the May-June malaise for base metals and mining company equities, the three-month correlation wandered about in negative territory (dark blue line) until a nearly straight line movement or “trajectory” into the upper right quadrant of positive correlation (marked by the green “+, +” box). This was a decidedly bullish move because when gold and copper prices move together, their price ratio is least disturbed and stability is restored. After July 22, the trajectory (recent data, magenta line) continued to improve nearly reaching the Nov. 26, 2010 level of positive correlation (blue diamond).

Conditions quickly deteriorated during the U.S. debt ceiling debate followed by the credit downgrade and a worsening European sovereign debt crisis. Like a crashing airplane the recent trajectory quickly flew into negative one month correlation (yellow “-, +” box) and then nose-dived into bearish inversion (red “-, -” box). The large arrow shows that Au:Cu correlation is nearly back where it began in early May.

Conclusion

If copper were to vote today, the red metal would shout “recession!” from the back bench to its more fortunate precious metal colleague. Not only are the ratio of the two at recession levels now but the journey there from historical norms has been as abrupt as startling with no clear indication for imminent return.

In December 2008, copper’s dramatic price decline presaged the S&P 500 bottom of March 2009. The Au:Cu ratio before Christmas of that year exceeded 570 lb/oz as copper price plumbed $1.30/lb. Clearly, there has not been a calamitous price decline and copper has shown some resilience recently by climbing back above the $4/lb-level. However, December 2008 was one year into the Great Recession and we may now only be at the doorstep of another dip down.

A positive turn in the fortunes of Western economies, better-than-expected Chinese demand or additional quantitative easing in the United States could easily influence the red metal’s vote. In any case, it may be sometime before we enjoy the commodity stability of last November or late July.

By Richard Baker, CP Analytics
http://eurekaminer.blogspot.com/

****

Disclaimer: The prices of precious metals and physical commodities are unpredictable and volatile. There is a substantial degree of a risk of loss in all trading.