Commodities send coded clues on inflation
After an 8-year period of remarkable stability, the ratio between gold and oil prices has broken down spectacularly.
The relative rise in gold is consistent with other indications that the market is bracing for a delayed upturn in inflation between 2010 and 2012.
From 2000 to 2008 one ounce of gold bought between 6 and 15 barrels of light sweet crude oil but for months the markets have been moving in opposite directions. In recent weeks, one ounce of gold has bought as many as 27 barrels of oil (https://customers.reuters.com/d/graphics/OILGOLDRATIO.pdf).
If both gold and oil prices encapsulate a view about prospects for the world economy and inflation, the divergent price moves present a seeming contradiction.
The surge in gold prices suggests investors are anxious to protect their capital against inflation, currency depreciation and bank failures. But weak or falling prices for oil and other commodities suggest investors are also bracing for a prolonged period of economic weakness and deflation.
How to reconcile these views? They cannot both be right.
If the massive liquidity injections into the banking system as a result of rescue packages and quantitative easing causes inflation to pick up, oil prices reflected in the forward curve will turn out to be far too low. If the world economy falls into a long deflationary slump, gold will be too high.
In either event, it ought to be able to trade the ratio, selling expensive gold futures to buy cheap oil ones, and wait for the ratio to converge back to more “normal” levels.
But such trades are more dangerous than they look.
Ratios can be remarkably stable and show strong trend-reverting properties for long periods of time. But when they break down, divergences often go further and last longer than most anticipate.
John Maynard Keynes warned that the market can remain irrational longer than the average investor can remain solvent. All but the strongest investors with deep pockets will struggle to meet margin calls until the ratio corrects and profits are made.
Moreover, it is impossible to be certain until afterwards whether the shift in the ratio represents a temporary divergence that will be corrected in time, or the start of a fundamental structural break.
In any case, the current divergence in gold and oil prices may not be as irrational as it looks. It probably reflects differences between institutional and retail investors about the timing of future inflation rather than the probability.
Both types of investor have recently shown interest in commodities as a hedge against inflation, currency depreciation and bank insolvencies.
But unlike large institutional investors, who can protect themselves from inflation and currency risks through inflation and currency swaps, inflation-protected government bonds, or futures positions in oil and industrial metals, retail investors have fewer options. Owning physical gold is one of the few ways they can protect capital in an inflationary environment.
Much of the heightened interest in gold has come in forms favoured by retail investors, such as coins, bars and holdings in exchange-traded funds (ETFs) (which give private investors an opportunity to “own” physical gold more or less directly through shares in a trust vehicle quoted on equity exchanges).
Different views about inflation embedded in gold and oil futures may therefore mark different views between retail and institutional investors, with the retail base more worried about an upturn in inflation, and professional investors more sanguine.
It probably also captures differences about timing. The whole objective of quantitative easing is to generate more inflation over time to counter the deflationary tendencies within the economy as a result of the slump.
But an upturn in consumer prices is unlikely to occur until a cyclical recovery is well underway, and could therefore be several years away.
Less sophisticated retail investors focused only on the longer-term inflation threat risk piling into commodities too early, paying several years worth of storage and financing costs (contango, or negative roll yield) before seeing an eventual upturn. Institutional investors seem content to wait until signs of a cyclical recovery and pick up of inflation become more imminent.
Gold is also a much more convenient and cheaper way than crude oil to buy medium-term protection from inflation.
Because of the huge storage charges, the cost of buying cheap oil at the bottom of the cycle and financing and storing it until prices and inflation pick up in two or three years time, is prohibitively high.
Gold is much easier and cheaper to store. The cost to buy gold or gold futures now and hold them until inflation picks up is little more than the cost of finance, which in a world of near-zero interest rates is almost nil.
For both retail and institutional investors, gold has therefore emerged as the vehicle of choice for protecting capital against a deferred break out in inflation rates in 2010-2012.
The stretched oil-gold ratio is a perfectly rational reflection of timing differences (deflation in the short term, inflation in the long term) and storage charges (high for oil, low for gold).
The current constellation of commodity prices does indeed send a carefully coded warning about the prospects for a pick up in inflation — but not for another 2-3 years.