Gundlach indicator: stable copper-gold means low yield volatility
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Copper-gold stability analysis enhances interpretation of the Gundlach indicator
November 11, 2019
Jeffrey Gundlach, CEO of DoubleLine Capital LP (DoubleLine®), noted in his 2017 forecast that the copper-to-gold ratio was a "fantastic" indicator of interest rates – specifically the yield on the benchmark U.S. 10-year U.S. Treasury. I have since written numerous Kitco News commentaries on this indicator which has proven to be a forecasting gift that keeps on giving (last commentary: Gundlach Indicator: Copper, Gold & Treasury Yields at a Tipping Point, October 15, 2019).
Monitoring the stability of the copper-gold ratio (CGR) can enhance the interpretation of this indicator. In volatile markets, stability analysis can anticipate highs and lows of the CGR and a change in direction for yields. For less volatile conditions, a stable CGR can portend periods of low yield volatility.
A tumultuous market week
Last week witnessed rallying equity markets and a surge in global government-bond yields. New optimism for an interim U.S./China trade deal propelled the S&P 500 to new records and pushed the U.S. 10-year Treasury yield towards 2%. On Thursday, the Wall Street Journal quoted Donald Ellenberger, manager of multisector strategies at Federated Investors, “Multiple markets are confirming what could be a regime change in sentiment.”
The U.S. and China had just announced they were ready to drop some tariffs but by Friday morning President Donald Trump dampened hopes for such a rollback. In Europe, new Brexit anxiety returned as Britain’s central bank appeared divided over its Brexit response. Unfazed, the S&P 500 still closed the week at a new record high with its volatility index (VIX) at a very low 12.
To lend perspective, the 10-year yield settled just below 2% or about where it was in late-July. That was followed then by a steep decline in yields to the September 3rd low of 1.43% and a VIX alarmingly elevated above 20 for much of the first half of August – the flipside to the “risk-on” posture of the last several weeks. A negative summer sentiment came from the same booger bears: U.S./China trade conflict and fears of a disastrous Brexit outcome, exacerbated then by the election of Boris Johnson in the U.K.
Jeffrey Sherman, Deputy Chief Investment Officer of DoubleLine®, characterized the summer market perturbation as a “burst” in a September 11th CNBC Business News interview:
Although there was this big momentum [Treasury] rally, they tend to come in bursts. And usually when you have these big movements, the bond market — like the stock market, like the credit market — tends to overshoot in both directions.
I believe the same logic can be applied to this week’s market action.
10-year Treasury yields march in step with the copper-gold ratio
Jeffrey Mayberry, Co-Portfolio Manager of the DoubleLine® Strategic Commodity Fund, has studied the relationship of the copper-gold ratio (CGR) and 10-year Treasury yields and makes this important observation:
The ratio’s absolute level is irrelevant. What matters is its direction – and whether the yield on the 10-year Treasury moved in the same direction or diverged. In past episodes of divergence, the 10-year yield has eventually tended to follow suit of copper-gold (“The Power of Copper-Gold: A Leading Indicator for the 10-year Treasury Yield,” Jeffrey Mayberry, DoubleLine® Funds)
Beginning in June, there is high positive correlation between the CGR and the 10-year yield – the relationship is presently not divergent. On the contrary, high correlation persistence has allowed the weekly development of high-fidelity yield models based solely on copper and gold prices. Figure 1 is a 3-month regression model of 10-year U.S. Treasury yields based on the ratio of copper and gold from August 13, 2019 through Friday’s close, November 8, 2019.
Figure 1 – U.S. 10-year Treasury yield model based on Comex copper & gold prices
Comparable to the weekly models that preceded it since June, the statistical error is 5.8 basis points (bps) with a goodness-of-fit, or R-squared, of 0.79399. Although the R-squared has fallen some in the last several weeks, it is on the rise again and errors of 1-standard deviation have remained in the 5-7 bps range since early summer.
Importantly, the model provides upper and lower 2-standard deviation bounds for yields. The upper bound suggests yields just above 2% are possible in the near-term with a floor near 1.8%. Friday’s yield estimate is only 0.9 bps from the actual yield (1.9242% vs. 1.9330%).
Note how yields have risen since the September 3, 2019 low to the levels in late-July.
A Stability Map anticipates highs, lows and periods of low volatility
A stability map, or lambda-Map©, of a commodity ratio experiencing high volatility is useful to divine directional change and anticipate a local extremum (maximum or minimum) of the ratio. Following Mr. Mayberry’s observation, this same technique applied to copper and gold prices should presage a directional change in the 10-year Treasury yield as well as the CGR.
Importantly, a stability map of a CGR exhibiting low volatility should also anticipate low volatility of the 10-year Treasury yield.
Realized volatility is an excellent metric for analyzing the stability of market valuations like the CGR. Expressed as a percentage, it is the standard deviation of the ratio normalized by its mean over a fixed time period. Fig. 1 is the 3-month (Y-axis) and 1-month (X-axis) realized volatilities of the CGR. A stability trajectory for each case sequentially connects the data points of the lambda-Map©.
Figure 2 – Copper-Gold Ratio Stability Map (lambda-Map©)
A 13-year history of CGR volatilities indicates that 50% of the time, 1- and 3-month volatilities are less than 4%. Accordingly, we say the ratio is stable when volatilities of both time bases are less than this limit. Beyond these limits, the ratio can decrease (increase) rapidly as gold and copper prices move in opposite directions. This can occur during “risk-off” market stress when gold is rising and copper is falling or “risk-on” market exuberance (gold falling, copper rising).
The stability trajectory shown in Figure 1 starts August 6th as markets became increasingly unsteady – gold prices rising and copper prices falling. The CGR quickly exits the left-half plane of stable 1-month behavior (shaded light blue) and enters the least stable upper-right quadrant. As gold prices pause, the trajectory takes a sharp turn counter-clockwise in the direction of improving 1-month volatility.
Such turns in the upper-right quadrant are key. In this case, the turn anticipates a bottom in the CGR and 10-year Treasury yield by 11 market-days (September 3, 2019). After these bottoms, stability steadily improves from both a short- and longer-term basis until the trajectory enters the “very stable” lower-left quadrant (shaded a darker blue). Presently, the CGR 1-month stability has near currency-like volatility of 1.7% on November 8th. The red arrow, however, suggests potential for decreasing stability.
What does this signal for Treasury yield volatility?
10-year Treasury yield volatility
Figure 3 shows the 10-year Treasury yield volatility from July 30, 2019 to last Friday’s close.
Figure 3 – 10-Year Treasury Yield Volatility
Yield volatility for this analysis is taken as the rolling standard deviation of yields over a 1-month period expressed in basis points. For reference, the 7-year average for such a volatility measure is 7.3 bps.
As market anxiety increased in early August, yield volatility increased from a below-average 4.6 bps to over 20 bps by the August 16 stability turn. Notably this is during a period of increasing positive correlation between yields and the CGR. Past the turn, volatility decreased as yields reached their low on September 3rd and then oscillated with declining peaks, and troughs near the long-term average.
Comparing the last two charts, the shaded stability rectangles of Figure 2 are superimposed on the time history of Figure 3. In Figure 2, the stability trajectory moves into the stable left-half plane (light blue) on August 26th and the yield volatility begins to pick up its pace of decline in Figure 3. As it enters the very stable region, yield volatility is confined to a range of 6.1 to 10.9 bps. A 1-month moving average suggests yield convergence near the long-term average of 7.3 bps.
Even with the jump in yields last week, the 1-month volatility bumped up just slightly November 8th to a below-average 6.3 bps (note red arrow of increasing volatility).
Stable copper-gold means low volatility – watch copper
For the “risk-on” case, it is difficult to imagine a sustained rise in yield volatility without a rally in copper prices. If the metals market believes a U.S./China interim deal is just around the corner, the red metal should soar above the $6,000/tonne ($2.72/lb) level. Although it did breech this level briefly last Thursday, December Comex copper retreated Friday to close at $2.682 per pound. In fairness, copper established an upward trend of higher-lows from the October 1st low of $2.515 per pound – a bullish sign for deal optimists.
Another clue is price action of the Chinese yuan (USDCNY). A real trade deal should strengthen the yuan below the important 7 USDCNY-level to pre-August levels. Friday closed at 6.99 but with a lot of daylight above the 6.88 close on July 31st. An additional headwind for “risk-on” sentiment returned this weekend as Hong Kong experienced one of its most violent days since June. Monday opened with the yuan above 7 USDCNY and December copper is trading down at $2.675 per pound.
My bet is on the Jeffrey Sherman “burst” scenario suggesting, for this case, that yields have overshot and will likely consolidate for the near term. The model in Figure 1 predicts yields somewhere in the range of 1.8% to 2.1%. I will be keeping a close eye on the copper-gold stability trajectory as well as copper prices and the yuan. Importantly, bearish movement of the latter two preceded the cold-water Presidential trade tweet on Friday.
Hats off again to the DoubleLine® team for discovering this important market indicator with proven performance in troubled markets. Copper-gold stability analysis enhances the interpretation of that indicator for both high and low volatility situations. The market events since spring provide testament to the power of that dual relationship.