MINING FINANCE / INVESTMENT
Copper gold ratio breaking down - a rare and scary event
After entering a potent uptrend in 2003, the copper: gold ratio has spent most of this year breaking down.
Posted: Wednesday , 05 Dec 2007
The ratio of gold:crude oil prices - in dollar terms - has long been used as a tool by various specialist investors, but the copper:gold ratio (CGR) can also be very useful. At this juncture, the Bank Credit Analyst is asking just what it is that the CGR is telling investors, with the most compelling factor by far being the "rare divergence between the price of base metals and precious metals over the past few months".
The event is seen as containing both a message, and as providing an investment opportunity. The price of copper, the leading base metal, has long been seen as a barometer of economic strength, while the price of gold can be most handily described as "a bellwether for liquidity creation".
As such, the corollary is that the CGR reflects the interplay between global economic trends and policy responses. History shows that the CGR plunged when central banks fell behind the deflation curve (that is, 1992-1993 and 2001-2002), and surged when rates were normalized or policymakers were struggling to cool economic growth (1994, 1999-2000 and 2003). During the 2003-2006 period, the CGR moved potently from roughly 0.2 to over 0.6 times, as calculated by BCA Research.
BCA Research argues that the current breakdown in the CGR ratio suggests that more liquidity is needed to reflate the global financial system and keep the economic expansion on track.
This could be a tough ask, given that measures of banking sector risk have exploded, starting early August, triggering an ongoing deterioration of liquidity in interbank money markets. Interbank lending has long been the main channel through which central banks affect financial markets and the economy. As interbank lending markets become increasingly moribund, so interest rate cuts become increasingly impotent.
In the physical markets, all metals are affected by idiosyncratic and specific supply and demand factors. The price of gold bullion is also impacted by its perceived monetary role, not only as a safe haven asset, but also as the most direct substitute for the dollar, which entered a protracted bear market early in 2002.
As for copper, prices remain on something of a knife edge. Copper - currently trading just below $3/lb, has fallen 25% in the past two months. Price trends for other base metals reflect similar trends. As a rule of thumb, the professional analyst community anticipates that a 1% reduction in global demand for copper could lead to a surplus of about 35,000 tons of copper in 2007. This would push inventory levels beyond historic metrics, and could trigger a further serious retrenchment of copper prices.
Investment demand, not by any means least from hedge funds and speculators, has played a significant role in pushing prices higher more quickly than would otherwise have been the case. Thus the professional analyst community anticipates long term copper prices of around $1.25/lb, significantly lower than current prices, and far closer to the $1/lb prices seen in 2002, before the CGR ratio started going into orbit. There are always contrarians; thus, overnight Tuesday, Shanghai copper futures rebounded, partly under influence of Barclays forecasting that the red metal will rise to a record next year on dwindling supplies and increased Asian demand.
More broadly, a growth scare continues to unfold in financial markets. Base metal prices, commodity currencies and materials stocks remain under heavy pressure. Overnight Tuesday, commodity currencies continued a downward slide in Asia. The Canadian dollar continued to suffer whiplash from the Bank of Canada's 25 basis points rate cut to 4.50% and the Australian dollar succumbed to a dovish interpretation of the Royal Bank of Australia's statement accompanying its unchanged rate decision. Specialist investors also point to how the London Metals Exchange index of traded metals has broken down both in dollar and euro terms. Caution appears to be the byword.