InterMarket Gold and Silver Analysis

Intermarket Relationships and Gold

From time to time we do a separate IMRA issue devoted to the trends and relationships that are governing the action in the gold market. As with all of our work the underlying premise is based on the idea that all of the various markets are in some way connected.

The most obvious starting point when looking at the trend for gold is in the foreign exchange markets. Gold is priced in U.S. dollars so, all else being equal, a decline in the external value of the dollar would lower the price of gold for all non-U.S. participants.

The first chart that we show contrasts the trend for gold against the rend for the Swiss franc relative to the dollar. As can easily be seen road swings in the franc mirror those of the price of gold in dollars.

The idea here is that during periods of dollar weakness the price of gold rises. The weaker the dollar the greater the impact so having some sense of what the dollar is doing relative to the European currencies provides some insight into what forces are specifically coming to bear on gold itself.

One of our basic views is that gold is more or less a hybrid of 'money' and 'industrial commodity'. Gold represents a portable store of value that is particularly attractive to the billions of people on this earth who do not have ready access to banks and a stable currency much less mutual funds and financial derivatives. We have been told that the advent of financial hedging through derivatives has eliminated the need for gold as a safe haven during times of uncertainty but we contend that a considerable percentage of the world's population has some need for an asset that can be carried away in times of political or civil unrest.

In any event, the price of gold is broadly affected by the price of money i.e. interest rates as well as the general direction or trend for commodity prices.

The second chart that we have included shows gold futures against a 3-year percentage Rate of Change (ROC) indicator for the combination of U.S. 30-year T-Bond futures and the Dow Jones AIG Commodity Index. As gold is one part 'money' and one part 'commodity' the sum of bond prices- which rise as interest rates fall- and a broad commodity index- which moves higher as demand for raw materials exceeds the current supply- makes a nice surrogate for the forces coming to bear on gold.

The 3-year %age ROC indicator works very nicely in this regard. Notice that it rises when gold is in a positive trend and declines when the price of gold is moving lower. In early 1999 the ROC indicator turned positive and remained that way to the present day.

The first two points that we wanted to cover were the relationship of gold to the broad trend of the U.S. dollar vis-à-vis the European currencies and the impact from both bond and commodity price trends.

At the moment gold is still enjoying a nice tail wind. However, one should keep in mind that any combination of sharply higher interest rates (lower bond prices), a return to strength by the U.S. dollar, and a collapse of broad commodity prices would certainly be a negative for gold.

Our culture seems to have raised central banks and central bankers to the status of demi-gods. Frankly, we only have to look at the Bank of England's decision in late 1999 to sell a substantial portion of its gold reserves so that the proceeds could enjoy a higher return in short-term U.S. and Euro-denominated paper to cast serious doubt on this notion.

The third chart today shows the price of gold in terms of the British currency. At present the price of gold relative to sterling is pushing into the top of the price channel that has turned back each rally for gold since the end of the 1970's.

It is our view that channels should always be respected. One should try to go long near natural support levels and then reduce or eliminate positions at the channel top. Notice that from 1983 to 2003 the price of gold from a British perspective has pushed up to the top edge of the channel on five different occasions before failing lower once again.

The price of gold tends to rise and fall relative to other commodity prices. To show this we have included two charts of the ratio of the price of gold to the CRB Index (a broad index of commodity prices).

The first chart shows the period from 1980 through into 1988. Gold made a relative low in 1982, spiked up to the resistance line into early 1983 and then declined once again into early 1985. From early 1985 through 1987 gold once again showed strength relative to other commodity prices.

By stacking this chart over top of the period from 1996 to the present day we can see that the 'relative' action of gold today is almost identical to that of 1987. This is somewhat significant because... the combination of a weak dollar, strong commodity prices, and rising interest rates created enough pressure in 1987 to create a very wicked 'crash' in the global equity markets.

Our point, then, is that if one looks closely at what is going on within the stock markets it becomes evident that capital is moving rapidly back into the commodity cyclical sectors. We have argued for some time that this is exactly what would happen and have made hundreds of chart arguments showing why companies like Phelps Dodge (copper), Inco (nickel), and Caterpillar would be expected to outperform the broad equity indices. So far, so good.

The problem is that we can't ignore the lessons from the past. The broad trend that has moved the major industrialized nations away from inflation and back towards disinflation or even deflation seems some-what susceptible to showing sizeable cracks when capital moves rapidly back towards those companies or sectors that tend to do well during periods of rising prices. In other words, just because these pressures created a stock market collapse in 1987 does not mean that we will see a similar crash in 2003 or early 2004 but... it is hardly a good idea to ignore the possibility. Our view is that one of the major markets is going to break and at this time we suspect that the first one to go will be the long end of the bond market.

Our next chart also happens to be one of our favorites. We show the ratio of gold to the Dow Jones AIG Commodity Index and then compare it to the price of short-term debt. In this case we are using 1-month LIBOR futures although we could easily have used 3-month U.S. T-Bill futures or eurodollar futures.

When LIBOR prices move upwards this implies that short-term interest rates are declining. The chart of LIBOR futures is virtually indistinguishable from Fed funds futures. Put another way, what we are looking at is a direct reflection of the policy choices of the U.S. Federal Reserve.

When LIBOR prices move upwards the Fed is reducing its target for the price of fed funds. We can see that during those periods of Fed 'ease' the price of gold rises relative to other commodity prices. Earlier on we stated that gold was part 'money' so the price of money- interest rates-has a powerful influence on the price of gold.

If we had taken this chart back to 1987 we could have shown that virtually from the moment Alan Greenspan become Chairman of the U.S. Federal Reserve the trend for gold relative to other commodity prices began to decline. This may or may not be a coincidence, of course, but from an intermarket perspective the basic argument is that each time gold got 'too strong' the Fed began to raise short-term interest rates. In fact, up until the end of 2001 there was a very powerful connection between commodity prices and short-term interest rates.

Perhaps the very best, and certainly the most dramatic, way to show this is through an overlaid chart of the CRB Index (commodity prices) and U.S. 90-day TBill futures prices. The CRB Index is shown through the black line and is scaled on the right side of the chart. Tbill prices have been turned upside down and are shown by the blue line and scaled on the left side of the chart.

We turned Tbill prices up side down for two reasons. First, because it is easier to see the relationship when the two lines move together instead of in opposite directions. Second, because now the line shows the trend for interest rates instead of prices.

What we see then is the relationship between commodity price trends (black line) and short-term U.S. interest rates (blue line) from 1986 to the present day. As commodity prices moved higher so too did interest rates. Conversely, as commodity prices broke lower interest rates quickly followed.

The big difference- what we term a 'divergence'- between the historical and the current trend began to build at the end of 2001. Commodity prices started to rise but the Federal Reserve apparently decided that the U.S. economy and/or equity markets were not ready for a tightening of credit conditions.

For the first time in the Greenspan era the Fed had turned away from trying to cap each and every increase in raw materials prices and in-stead seems almost determined to help inflate them to ever higher levels.

Notice that the CRB Index has just recently broken up through the top of the major price channel that has acted as support and resistance for more than the past 15 years. The cynical would argue that the Fed not only always gets what it wants but it usually gets more than it wants. If its goal was to push the U.S. economy away from the dangers of deflation then the likely outcome will be a stronger than expected inflation rate. This, of course, will inevitably result in the Fed raising short-term interest rates much further and more rapidly than they would have had to if they hadn't let the genie out of the bottle in the first place.

How does this relate to gold? In any number of very important ways. First off, however, we will return to our earlier observation that short-term interest rates 'should' have begun to rise as early as the end of 2002.

When we look at the trend for commodity prices (CRB Index futures) and the U.S. dollar (U.S. Dollar Index futures) we can see that the two began to move in opposite directions around the start of 2002. One could argue that the U.S. dollar was 'too high' and needed to decline in the aftermath of the collapse of the twin tech and telecom bubbles but that is a story for another day. In simple terms the most powerful determinant for the trend of any country's currency is the relative difference between its interest rates and those of its major trading partners.

To explain we have included a comparative chart of the Japanese yen futures and the price difference between euroyen futures and 1-month LIBOR futures.

The yen, of course, is shown relative to the U.S. dollar. A rising line means that the yen is appreciating against the U.S. currency. The euroyen minus LIBOR combination requires a bit of explanation.

Euroyen prices reflect the interest rate paid on yen deposits by non-Japanese banks. LIBOR, as we mentioned earlier, is largely a reflection of the funds rate target set by the Federal Reserve.

If euroyen prices are, say, 99 then the interest rate paid on yen deposits is roughly 1%. If LIBOR prices are, say, 95 then the rate paid on dollar deposits is around 5%. Using these numbers a difference of '4' (99 minus 95) would mean that U.S. interest rates are around 4% higher than those of Japan.

One might intuitively think that as long as U.S. rates are higher than Japanese rates that money would flow from Japan towards the U.S. and, as a result, push the dollar up against the yen. In fact, in some ways the opposite is true but we will need to return to the chart to explain.

In early 2002 the chart shows that the euroyen- LIBOR spread reached as high as 6.5. Only when the spread peaked and started to decline did the yen start to lose relative value against the dollar. The yen continued to depreciate until the start of 2002 as the Fed cut interest rates to the point where the difference between U.S. and Japanese rates had tight-ened in to around 1.5%.

Even as the spread has worked lower into 2003 the yen has risen. This is the markets' way of saying that as long as U.S. short-term interest rates are less than about 2% higher than similar Japanese interest rates capital will flow out of the U.S. and back towards Japan. To this extent one could argue that the Fed is following a very determined policy of devaluing the dollar. Since we already know that gold benefits from both a weak dollar and lower interest rates one could take things a step further and argue that knowingly or unknowingly the Fed has been actively working to support the price of gold. One has to appreciate the irony inherent in that thought.

Returning to the parallel between today and 1987 the most glaring difference would be the response by the Fed to both dollar weakness and commodity price strength. Instead of fighting it by tightening credit conditions- which, naturally, created a stock market crash - the Fed seems intent on simply letting the markets run at will. Our problem with this is that major divergences within the markets rarely last for an extended period of time before prices are literally forced to move back together again.

Now... in an earlier chart we showed the ratio of gold to commodity prices and compared it to short-term U.S. Tbill prices. From the start of 2002 to the present day the ratio has literally hugged the under side of the channel top. Gold has not broken out relative to commodity prices but has instead been allowed to work higher as commodity prices in general have moved upwards.

We mention this because as the pressures build any number of markets may start to exhibit the sort of sharp and unexpected price moves that the creators of and investors in derivatives products tend to find some-what destabilizing. Those, for instance, that have borrowed at short-term interest rates based on a spread of the LIBOR rate could find that the general Wall Street view of flat interest rates through most of next year will quickly be replaced by a doubling, tripling, or quadrupling of their borrowing costs. We do not have to look back further than 1998 (LTCM) to realize that almost anything can happen to the financial and banking systems when prices start to rapidly trend in unexpected directions.

On Friday the U.S. Bureau of Labor Statistics announced that the seasonally adjusted increase for finished goods (PPI) rose 0.8% for the month of October. On an unadjusted basis finished goods prices have been around 3.4% higher than year earlier levels for the past three months.

In the face of what we would consider to be a rather negative report on inflation the yields on Treasury debt right through the yield curve declined. The reaction following Tuesday's CPI report may be different but it does show that the market is still convinced that the Fed will hold short-term interest rates lower for some time. Otherwise, why would anyone lend money to the U.S. government for five years at 3.2% when at least one measure of inflation remains at 3.4%?

From an intermarket point of view we try not to argue with the markets but rather come to terms with what has to happen before a trend will truly change. One way we do this is by looking at the various ratios.

We show U.S. 2-year T-Note futures prices and the ratio of the price of gold to the Japanese equity market (Nikkei 225 Index futures). The gold/Nikkei ratio has moved higher as U.S. interest rates have declined. This not only confirms the link between gold prices and shorter-term U.S. interest rates but adds a new factor- the Japanese stock market- into the mix. As long as the Nikkei is not stronger than gold one can see that the trend towards lower interest rates remains intact.

Another way- and the last for today- is by looking at the ratio of gold to copper. We show this ratio compared to U.S. 10-year T-Note futures prices. As recently as this past week strength in copper and the Nikkei had reached the point where an imminent decline in bond prices appeared likely. Once again, however, the price of gold managed to adjust just high enough to keep the current trends intact.

In summary, the trend for gold remains positive and will likely remain that way as long as the markets are convinced that the Federal Reserve has no immediate need to start tightening credit conditions. This means that the dollar will remain weak while commodity prices in general trade higher. On virtually a daily basis this works to create pressure within the various capital markets.

Our expectation is that the bond market will break first. There are any number of ways to watch for this but one of the simplest is to keep an eye on the Japanese equity market. Any push above 11000 by the Nikkei should be sufficient to start bond prices moving lower.

If the capital markets behave in a more or less 'normal' fashion the equity markets should continue to move higher for a number of months after bond prices start to decline. If you have followed our logic so far you may be able to see that lower stock prices today would only extend the current trend. By this we mean that if the equity markets decline now this would extend the bond market's price rally and keep downward pressure on the dollar. Commodity prices would continue to rise as the dollar loses value and in due course the equity markets would steady out and move upwards again. This sequence would repeat itself until interest rates were finally forced upwards which would, in turn, set the stage for the next equity bear market.