It is the dog days of summer, and tensions over North Korean missiles and nukes startle a few sleeping dogs. On Tuesday, August 8, President Donald Trump delivers a sobering comment to reporters at his Bedminster golf course: “North Korea best not make any more threats to the United States. They will be met with fire and fury like the world has never seen.” Comex gold rallies to $1,271.0 per ounce.
This ruckus doesn’t blunt copper’s summer rally as it posts prices not seen since late 2014. Other base metals join the surge with zinc scoring a new high for the year and aluminum scaling a two-and-a-half-year peak. The ratio of copper-to-gold prices rises to mid-2015 levels shortly after the president’s remarks. The yellow metal’s move is sound but outpaced by its red metal companion. Very curious.
In his 2017 forecast, bond guru Jeffrey Gundlach made a prescient observation about gold, copper and 10-year U.S. Treasury note yields. Midyear, he called for those yields to be in a range of 2.7 percent to 2.8 percent by the end of the year, perhaps higher. Several hours before “fire and fury,” Mr. Gundlach appeared on the CNBC Business News. “The copper-gold ratio going up as strong as it has suggests to me yields are going to break out to the upside,” he said. In the same interview, he predicted gold was ready for a breakout above the $1,280 to $1,300 level on some catalyst — likely geopolitical.
So far, yields are still low and below the 2.4 percent tipping point identified in the interview. By that Friday morning, Comex gold nearly touched $1,300 at $1,298.1 per ounce.
Not too many people have become rich betting against Gundlach. If you believe him, how do you fit these seemingly contrary pieces together to forecast prices for two of Nevada’s prominent metals?
In his forecast, Gundlach, founder and CEO of DoubleLine Capital LP, noted that the copper-to-gold ratio is a “fantastic” coincident indicator of interest rates. I did a little research and built an interest rate model based on copper and gold alone. He’s right! In fact, this relationship has grown even more fantastic since his forecast eight months ago.
First, a little background. U.S. debt obligations break into three categories: Treasury bills, notes and bonds. Treasury bills are short-term maturities of a year or less. Treasury notes span a period between one and 10 years; Treasury bonds, more than 10 years. Treasury yields, or the income return from investing in those securities, affect many consumer loans, such as fixed-rate mortgages. Gundlach chooses the midrange 10-year note as a benchmark for interest rates in his comparison to gold and copper prices.
The first graph shows my model, based on Gundlach’s assumptions, versus actual 10-year note yields over a two-year period. I prefer to use the gold-to-copper ratio, or GCR, since folks out this way think in “pounds of copper for a troy ounce of gold,” consistent with the venerable gold-to-silver-ratio or GSR. The results are unchanged except the GCR bottoms as Gundlach’s copper-to-gold ratio peaks.
The error in this model is very small compared to the average yield over two years. It is the equivalent of going 76-84 mph on the new 80 mph stretch of Interstate 80, about a 5 percent wiggle. Most drivers reasonably assume that difference won’t set off State Trooper lights. When Gundlach made his earlier forecast, the error was a bit larger, so the relation has improved since the beginning of the year. A good model to date; no tickets for excessive error yet.
On the horizon
My model can determine what the GCR will be given Gundlach’s future interest rate forecast. The second graph shows the GCR for 2017 together with projected GCR levels.
Note that when the 10-year yields were below 2.2 percent, the GCR peaked to an elevated 512 pounds per ounce. The ratio has trended lower with rising yields and briefly dipped to the 430-level after the president’s “fire and fury” remarks. The model suggests further ratio compression to even lower levels given Gundlach’s 2.7 percent to 2.8 percent prediction; 389 and 368 pounds per ounce respectively.
In the CNBC interview, the bond guru offered additional insight: “When the copper-gold ratio is rising [i.e. GCR falling] it’s incredibly suggestive that something is going on that might be a little inflationary,” he said. “It suggests to me yields are going to break out to the upside. ... The leg up in yields will be a catalyst of volatility in the market.”
Returning to the I-80 analogy, volatility can be likened to a driver who gets tickets for excessive speed and going too slow on the same day. A volatile market produces price swings that are large and erratic. Recalling 2011, copper set an all-time record high in February, followed by a dramatic crash caused by slowing China demand and U.S. debt crisis. While copper headed down the mineshaft, gold pegged its all-time record that October. That’s called a volatile market.
For months, U.S. stock markets have inched higher to new all-time records, sometimes on a daily basis. This has resulted in historically low volatility for equities. Gundlach uses a basin/range analogy to explain an anticipated spike in volatility. He notes that Mount Whitney, the highest point in the Continental United States, is very close to Death Valley, the lowest point. This relation is not by coincidence. Nevada miners know it is driven by plate tectonics. We’ve got lots of basins and ranges in our state caused by the massive collision of Pacific and continental plates. Market volatility has been lazing about in Death Valley, Gundlach said, but is ready to soar to Mount Whitney heights — a tectonic shift in markets.
By the time you read this column, all hell might be breaking loose or the dogs might be fast asleep again on the porch. If we remove geopolitical concerns, there is evidence that economies worldwide are improving. Some economists use the phrase “synchronous recovery” to argue improving demand for raw materials. The 10-year Treasury yield is also an accepted gauge of U.S. economic growth, so expectations for higher rates and improving gross domestic product are consistent. So far, the U.S. Federal Reserve appears to be on the same page as they slowly increase their benchmark rate.
Unless missiles are flying through the air, rising rates in a low-inflation environment are a serious headwind for gold prices. Why place money in gold when you can earn a decent return from interest-bearing assets? In this scenario, a declining GCR says copper continues to outpace gold. By the model, a 2.7 percent yield results in a 389 pound per ounce GCR; $3 per pound copper implies $1,167 per ounce gold. Ouch.
However, if rising inflation is added to the picture, as Gundlach suggests, gold’s outlook improves. Investors seek real returns or the difference between yield in nominal terms and inflation expectations. If the latter rises in concert with the former, gold regains some shine.
It is also important to note for the 148 market days shown in the second graph, gold price below $1,200 has only occurred for 5 days – about 3 percent of the time. This reinforces the notion that there is strong support at the $1,200 level, and that a return to $1,100 territory is unlikely. Even lacking geopolitical shock, there appears to be enough background fear and uncertainty to keep the yellow metal in the upper levels of the mine.
Gundlach sees value in gold in the long-term and uses it as a hedge against rising volatility and lower equity prices. In a recent Reuters interview, he said, “Gold looks cheap compared to markets that have rallied a lot ... .”
How then do we explain the very low GCRs suggested by the second graph? If falling GCRs and a bump in rates do indeed trigger high volatility, you can throw once-useful models overboard as investors flee the ship. I contend that descending below the 400-pounds-per-ounce level is unlikely for 2017 and that there are good reasons to be bullish for gold prices going forward — some more scary than others. On the high side, $1,400 per ounce is certainly possible for gold given a geopolitical shock. Given a less threatened and improving global economy, $3-plus per pound copper is in the cards and gold above $1,200 likely.