Gold Country – McCoy Ridge, Eureka, Nevada
Jul. 7, 2014
My March 17, 2014 Kitco commentary fired a warning flare. Comex gold just made its $1,392 per ounce intraday high for the year but all was not well in the commodity house. When industrial commodities oil and copper move in different price directions to the yellow metal it is prudent to take caution. First quarter concerns about emerging market currencies, bad economic data from China and a spiraling Ukraine crisis played havoc with commodity prices. The divergence between copper and crude oil relative to gold had widened to levels not seen since the Arab Spring 2011 or the onset of the Great Recession. Figure 1 is the divergence plot from that commentary updated from October 2006 through last Thursday’s holiday close.
Figure 1 – Copper-WTI Divergence Relative to Gold (Oct. 18, 2006 to July 3, 2014)
The March analysis was based on the most active futures contracts for Comex gold and copper, and Nymex WTI crude oil. The particulars of the plotted divergence (D) are explained in note 1 below.
Divergence in the commodity family is rarely a good sign for commodities or other markets, especially when it reaches levels comparable to periods preceding significant market stress. These are shown by red circles above the red dashed line at the divergence level peak reached March 10. A green circle marks the greatly reduced divergence as markets closed for the Fourth of July.
As pointed out then,
- The divergent spikes associated with Great Recession and Arab Spring 2011 occurred during a period of rising gold and oil prices and falling copper prices
- The spikes occurred in pairs approximately 1-2 month apart
- The spikes were followed by volatile markets which included benchmark gold records and precipitous drops in key commodities.
No market apocalypse yet…
It is nearly four months later and a second divergent spike never appeared. Although copper did dive below the key $3 per pound-level in March it has been in rally mode since mid-June advancing nearly 9% from the June low to a $3.2795 close for the holiday weekend. WTI spiked above $105 per barrel in early March but has made higher highs since propelled by increasing tensions in the Middle East. Instead of besting its March high, gold stumbled below $1,250 in June and has just recently found some headroom above $1,300 closing at $1,320.6 per ounce.
With respect to point (3) the S&P500 Volatility Index, or VIX, dropped below its January 2007 low Thursday, there are no precipitous drops in key commodities and even the wildest-eyed gold bug is not predicting a new benchmark record for the near term.
Why not?
Although there are tempting parallels with 2011 there are at least two new elephants in the room: a building domestic recovery and continuing, albeit tapering, third phase of quantitative easing (QE3). The second 2011 divergent spike occurred in early May near the end of the second phase of easing (QE2) in June and before the disastrous U.S. debt downgrade that August. By fall 2011, when gold made its all-time record and copper prices crashed, domestic recovery was in grave doubt and there was no QE-safety net under commodity prices. Instead of today’s record breaking stock markets, equities significantly corrected and volatility soared. The VIX made multi-year highs not lows in the second half of 2011.
To date, the broader 2014 market response to a slowing China and crises in the Ukraine, Syria, Iraq and now Israel is nearly exact opposite of 2011.
Drilling a little deeper…
Even though market calamity has yet been avoided for 2014, divergence remains a troubling sign. For example, gold is positively correlated with copper more often than not; precious and base metals typically obey a pack mentality. From late-2006 to the end of 2013, the 1-month and 3-month rolling correlations of copper and gold were simultaneously positive 62% of the time. From January through June that number is a shockingly low 3% - the yellow metal had been culled from the pack.
Positive 1- and 3-month correlations of WTI oil and gold over the longer period are correspondingly 56%; 2014 scores 27%. Oil’s higher-than-copper’s 2014 number reflects the tight correlation with gold in the early innings of the Ukraine crisis but is nonetheless low compared with the previous record.
A correlation map is a useful tool for visualizing these relations. Figure 2 is a plot of rolling correlations (rho) for oil and gold, and copper and gold from March 3 to March 17, 2014.
Figure 2 – Copper & Oil Correlation Map (March 3 to March 17, 2014)
The vertical axis is 3-month correlation; the horizontal, 1-month. Data points in Figure 1 are correlation pairs for the indicated commodity and the lines between points define the correlation trajectory (oil gray, copper red). The oil trajectory begins in the upper-right hand “bullish” quadrant where 1- and 3-month correlations are simultaneously positive. At the start of the oil trajectory (note the direction of the gray arrow), oil and gold are tightly correlated as indicated by the closeness of the points and high quadrant position (rho > +0.6). Oil and gold prices initially rose together.
By March 3, copper prices fell on gold’s rally forcing the copper trajectory outside the bullish quadrant. The trajectory after March 3 was also ominously pointed in the direction of the lower-left “danger” quadrant where 1- and 3-month correlations are simultaneously negative.
In a correlation map, divergence (D) is the distance between two trajectories – in this case oil and copper. The blue dashed line denoted D0 is the divergence of oil and copper relative to gold on March 3. The divergence (or distance) builds until reaching a maximum on March 10 following the Russian occupation of Crimea on Feb. 27. On that Monday, China announced an 18% drop in exports several days after the China Chaori Solar loan default shocker. Copper prices plunged to July 2010 levels (Note 2). On March 12, the red metal plumbed an intraday low of $2.909 per pound, nearly 15% below its 2014 debut price.
After peak divergence, oil began to rapidly distance itself from gold as seen by the wide point spacing in the oil trajectory. By the time gold made its intraday 2014 high of $1,392 per ounce, 1-month correlations with both oil and copper were both very negative (rho < -0.6) and divergence declined accordingly (D1<Dmax).
The oil trajectory would soon join copper in the danger quadrant as red metal prices recovered, oil prices found new highs and gold prices fell into $1,200 territory. Some of the boil was off geo-political tensions, China news improved and the U.S. economy showed further signs of health.
Figure 3 shows a more recent correlation map from June 16 to July 3, 2014.
Figure 3 – Copper & Oil Correlation Map (June 16 to July 3, 2014)
From gold’s perspective there is a significant improvement underway. Both oil and copper trajectories have re-entered the bullish zone with substantially reduced divergence. Minimum 2014 divergence occurred June 18 (Dmin) but current performance (D4) is still quite encouraging.
Gold has returned to the pack.
What Next?
Although gold held value on a weekly basis, the strong nonfarm payroll report Thursday erased most premium gained on building geo-political tensions in the Middle East. The weekly Comex intraday high Tuesday week touched $1,334.9; traders returning from holiday have brought the yellow metal down to $1,315 in morning dealings – lower but still above the key $1,300-level.
The metallic hero of last week was copper gaining 3% to trade above $3.25 per pound on hopes of a stronger-than-expected domestic recovery and stabilizing conditions in China. The red metal has gained value compared to gold and now falling oil prices. Today Comex copper has pulled back but is still above $3.25 and Nymex WTI is holding above $103 per barrel.
Relative to copper, gold is now trading near fair value. Although oil prices are below crisis levels, gold still trades at a discount to WTI crude (Note 3). One feature of trajectories being in the bullish upper quadrant in Figures 3 is a stable gold valuation relative to the reference commodities. As long as gold runs with the pack, it should hold its value relative to these key commodities.
All in all, it appears oil, copper and gold may be preparing for the summer doldrums.
But is there a darker outcome?
Tom McClellan, author of McClellan Financial Publications, believes gold is on the cusp of a major cycle low in gold price (July-August) that will take out the December 2013 low. If that occurs, my estimate is a tumble to the $1,110 to $1,120 range. Regardless, my year-end forecast is a range of $1,100 to $1,200.
Why all the gloom? Although the March divergence did not result in a major market upset, it did illustrate how quickly gold can be abandoned in an environment of positive growth and low inflation. Gold price has become a slowly leaking tire that occasionally gets a pump from geo-political tensions – the tire still leaks after conditions improve.
In my view, until inflation expectations materially increase, gold price has further to decline. It is likely that gold’s triumphant return to the bullish quadrant will be brief. If the latter half of 2011 is remembered for record gold prices amid falling equities and commodities, the reverse may very well be in store for the remainder of 2014.
From the heart of North American Gold country – Cheers!
Note 1: The copper-WTI divergence indicator, or D(Cu-WTI, Au), is based on differential rolling correlations of two different time bases. If CORRELi (Cu, Au) is the rolling correlation of Comex copper and gold prices over time period i, then the differential correlation of Nymex WTI crude and Comex copper relative to Comex gold is:
DELTAi (Cu-WTI, Au) = CORRELi (Cu, Au) – CORRELi (WTI, Au) for time base i
D is the geometric norm for two time bases i & j:
Di,j (Cu-WTI, Au) = SQRT (DELTAi (Cu-WTI, Au)^2+ DELTAj (Cu-WTI, Au)^2)
For the above analysis, the time periods are 1-month and 3-month (i=1 & j=3).
Since correlations are bounded by +/- 1, the theoretical maximum D is SQRT(4+4) or 2.83
Note 2: Silver, Copper Could Weaken Further If Chinese Economic Data Disappoints; Copper Breaks $3/Lb (Debbie Carlson of Kitco News; Tuesday March 11, 2014 1:19 PM)
Note 3: Since the Lehman Brothers bankruptcy on Sept. 15, 2008, the average gold-to-copper ratio is 407 pounds per ounce. The closing ratio on July 3, 2014 was 403 pounds per ounce. The corresponding gold-to-WTI ratio mean is 15.9 barrels per ounce; the closing ratio was 12.7.
By Richard Baker
The Eureka Miner
Eureka, Nevada
http://eurekaminer.blogspot.com/
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