Subscribe
Share
Share
Embed
Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management biweekly asset allocation report for June 10, 2024. I'm Phil Adler. A comparison between copper and gold prices has, in the past, been a reasonably reliable predictor of bond yields. But it looks like this indicator no longer works. Confluence Investment Management associate market strategist Thomas Wash joins us today to explain why.
Phil Adler:Thomas, the indicator we're looking at today is called the copper to gold ratio. Now what is it exactly?
Thomas Wash:The copper to gold ratio is a valuable gauge of investor sentiment towards risk. It compares the price of copper, an industrial metal that thrives during economic expansion, to gold, a traditional safe haven asset. A rising ratio indicates a risk on mood, suggesting investors are confident in economic growth and are willing to embrace riskier assets. Now, conversely, a declining ratio signals a risk off environment as investors seek the perceived safety of something like a gold due to economic uncertainty or market stress.
Phil Adler:And how has it been useful in the past in predicting bond yields for longer term bonds with terms of 10 years or greater?
Thomas Wash:Well, the 10 year treasury yield often trends along a rising gold to copper ratio, but they reflect risk appetite differently. The copper gold ratio indicates economic growth optimism through rising copper demand, while treasury yields can signal both confidence and inflation worries. Now investors might sell bonds, which raises yields, if they expect strong economic growth to push up inflation. And they might buy bonds if they assume duration is no longer a problem.
Phil Adler:So when the price ratio of copper to gold has risen in the past, investors could expect longer term bond yields to rise as well to anticipate inflation. How accurate has this relationship been in the past?
Thomas Wash:Historically, the copper gold ratio has explained around half of the movement in 10 year treasury yields over the past 15 years, making it one of the most influential indicators for bond investors alongside factors like the US dollar and federal funds rate. However, its effectiveness likely benefited from a period of stable inflation expectation. When inflation is well anchored, the 10 year Treasury yield can more closely track movements in gold prices. This is because both are viewed as safe haven assets, making them more attractive to investors seeking shelter during times of trouble.
Phil Adler:And when did the reliability of the indicator in predicting longer term bond yield start to break down?
Thomas Wash:The COVID 19 pandemic disrupted this historical relationship. Previously, this connection was quite strong, leading some hedge fund analyst to rely heavily on the copper gold ratio as a signal to buy and sell bonds. However, the link has a history of vulnerability as evidenced by the breakdown following the 911 attack. It took several years and the subsequent financial crisis for the relationship to reestablish itself.
Phil Adler:So, Thomas, is it fair to say that this indicator only worked well in a low inflation or low interest rate environment?
Thomas Wash:Well, I I I think that is mostly correct. In our view, low inflation expectation and a stable growth outlook underpinned the stable relationship between the ratio and long term treasury rates. This environment allowed investors to comfortably hold long term assets without fearing a decline in purchasing power. However, the post pandemic world has disrupted this dynamic. Investors now face an economy increasingly resistant to rising interest rates while inflation remains stubbornly persistent, thus making US government bonds less attractive.
Phil Adler:Well, let's explore this further. Has the increase in government deficits played any role in the breakdown of the copper to gold ratio as a useful indicator of longer term bond yields?
Thomas Wash:The relationship between the copper gold ratio and the treasury yields isn't straightforward. Government stimulus spending has impacted interest rate expectations. The resulting rise in government debt and inflation has pushed investors towards seeking higher returns on 10 year treasuries and exploring alternative assets during times of uncertainty. Now at the same time, geopolitical tensions has further amplified this shift with emerging market central banks stock piling gold to mitigate risk from potential US sanction. This increased demand for gold has put downward pressure on the copper gold ratio.
Phil Adler:Lots of, new bond supply, Thomas, will be coming to market to service the deficit, the federal deficit. At the same time, the Federal Reserve is buying fewer bonds to replace maturing debt. Has this Federal Reserve policy also affected the copper to gold ratio as an indicator reveals?
Thomas Wash:Yes. Monetary policy adds another layer of complexity to the relationship. The Federal Reserve's tightening actions has triggered a steeper rise in short term treasury yields compared to long term ones, therefore, inverting the yield curve. This inversion encourages investment in 10 year bonds as investors can secure higher returns with shorter maturities while avoiding the drawbacks of lower liquidity and longer duration.
Phil Adler:A few moments ago, Thomas, you mentioned foreign central banks also contributing to the this change through the metals market. Could you elaborate on this point? Explain how their actions are impacting the current situation.
Thomas Wash:The Russia Ukraine war has triggered a surge in gold buying by BRICS nations led by China. This likely stems from anxieties about potential friction with the US, particularly over Taiwan, and the risk of losing access to dollar denominated assets. This collective dash for gold as a hedge against US retaliation has buoyed gold prices, weakening the copper to gold ratio despite a recent uptick in copper prices.
Phil Adler:Well, what would it take for the traditional relationship between the copper gold ratio and longer term bonds to be restored?
Thomas Wash:For the relationship between the copper gold ratio and treasury yields to normalize, two factors need to adjust. 1st, investors need to regain confidence in the Federal Reserve's ability to tame inflation and return it to its 2% target in a reasonable time frame. 2nd, the US and China need to build trust. You know, Beijing fears of US retaliation for potential intervention in Taiwan is a primary driver of recent gold price increases. If the 2 superpowers can find common ground, gold prices may stabilize at a level reflecting under economic fundamentals.
Phil Adler:Is a restoration of the historical relationship likely, do you think?
Thomas Wash:There are headwinds that could prevent a near term return in the relationship. Several hot CPI reports in the Q1 has stoked worries about sticky inflation, challenging the Federal Reserve's ability to achieve its 2% target. Adding to the headwinds, the recent election of a pro independence leader in Taiwan has further strained US China relations, raising concerns about a potential conflict. However, there is a potential silver lining. Signs of a slowing US economy, evident in weak consumer demand from April's retail sales and personal consumption data, suggests that the economy may be slowing, which should alleviate some price pressures.
Thomas Wash:This in turn could bring down Treasury yields to a level more consistent with what the copper to gold ratio suggests.
Phil Adler:Thomas, it seems like there are multiple trends, all pointing to higher inflation for the longer term, And that might mean that many predictors which have been useful in the past are no longer useful. Is that perhaps the main takeaway from our discussion today for investors?
Thomas Wash:Yes. In fact, our long term outlook anticipates a period of higher inflation than what investors are familiar with. This expectation stems from two primary factors, the potential deglobalization and persistently tight labor markets. These factors could prevent Treasury yields from reaching their pre pandemic lows as inflation is likely to consistently stay below the Fed's 2% target. Additionally, a fracturing geopolitical landscape may incentivize countries to hold more gold as an alternative reserve currency, further disrupting the historical relationship between the copper gold ratio.
Phil Adler:Thomas, one last question. Confluence has been bullish on gold prices, which certainly has been a correct reading over the past 5 years. The price of gold in dollars is up according to one chart I've seen over 13% just in the past 6 months. Going forward, does confluence expect more of the same and does the firm have a target price for gold?
Thomas Wash:Well, that's a very complicated question. Central Bank actions have distorted markets, so our traditional model suggests gold is significantly overvalued. However, momentum indicators hint at a potential slowdown in the price increase. So we anticipate gold to end the year within a range of $2,250 $2,500.
Phil Adler:Thank you, Thomas. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer buy or sell any security. Our audio engineer is Dane Stoll.
Phil Adler:I'm Phil Adler.