By Jason Pearce
Despite the fact that there are different fundamentals that drive the demand for industrial metals and precious metals, there still appears to be a link between the price trends in these two sub-sectors of the metals category. If one were to take a very macro view, perhaps this price correlation is due to the fact that trends in inflation and economic growth impact both.
Using gold as the representative for precious metals and copper as the representative for industrial metals, a long-term price chart of the two reveals two things: First, gold and copper to tend to move in the same direction a majority of the time. Second, it shows that the copper market tends to be more volatile and sensitive to price swings than gold.
It makes sense that copper reacts to fundamental trends more quickly than gold. After all, the global gold supply is so large that the annual production and consumption changes equates to somewhere around one percent of the total supply. It’s almost as if most of the gold in the world simply gets transferred back and forth from the vault of one country’s central bank to the vault of another country’s central bank. Therefore, the value of gold is much more likely to be shaped by interest rates and inflation expectations rather than noticeable swings in actual production and consumption.
Copper, on the other hand, is used explicitly for industrial consumption. More than two-thirds of the world’s red metal goes directly into building construction and electronics. As goes the construction industry, so goes the copper market.
Ugly and Getting Uglier
Both precious and industrial metals have been in bear markets for well over four years now. Slow global economic growth and a lack of inflation have been weighing on both sectors.
With the threat of an interest rate hike from the Fed looming over the market and the US dollar at the highest level in many years, gold continued to push to new multi-year lows this week. Since central bank monetary policy tends to run in trends, the outlook is that the eventual rate hike from the Fed could be the first of many. If not, it would only be because the US economy is now growing at a fast enough clip. Either way, this is not supportive for gold.
Copper also continued its downward spiral as China is now experiencing the slowest economic growth in one-quarter of a century. Since they are the world’s largest consumers, the slowdown is creating a serious glut as copper supplies get stockpiled in the warehouses. There doesn’t appear to be any light at the end of the tunnel, either. Goldman Sachs is forecasting that the oversupply will last until at least 2019.
The current fundamental outlook does not bode well for any commodity traders who are trying to buy a bargain in the metals right now. Furthermore, with both gold and copper tumbling to fresh multi-year lows, the reward-to-risk scenario down here is not anything spectacular for short sellers. On the surface, it would seem that the best metals position for traders and investors to get into right now is flat.
The Relationship between the Blonde and the Redhead
Because of the correlation between the precious and industrial metals, it only makes sense to examine the historic relationship between the two. This can reveal potential trading and investing opportunities that may not exist in the underlying commodities themselves. This is a major advantage that spread traders have.
Since both gold and copper topped at record prices a few years ago, looking at the ratio between the two markets will normalize the relationship and give us a true perspective on whether or not it has reached historically extreme levels during this bear market. We can do this via the futures markets by dividing the value of a 100-ounce gold contract by the value of a 25,000-pound copper contract.
As it turns out, the ratio recently pushed above 2:1 and surpassed the January high. It is now matching the 2011 peak. This is a significant event. Over the last twenty-five years, the ratio has only been at 2:1 or higher on a few occasions and the financial crisis was the only time it has been considerably above this level. Therefore, we know that the gold/copper ratio has reached an important inflection point.
We believe that the gold/copper ratio is at a do-or-die level. If it follows the normal course, we should be looking for a reversal somewhere in this area. If so, it could put the ratio on course for a decline to somewhere around 1.2:1. To do so means that ‘Dr. Copper’ is finally outperforming gold. In all likelihood, this would occur if the world economy is making a rebound. Whether or not this will turn into a secular trend will be left to be seen, but it would mean that we’re at least getting some respite from the current overwhelming bearish environment for commodities.
The reversals off the peaks in 1993, 1999, 2003, 2009, and 2011 allowed copper to outperform for periods of roughly one and a half years to three years. Therefore, a trend reversal in the gold/copper ratio sometime soon would imply that traders should be positioned on the long side of copper and the short side of gold (on a spread basis) through 2016 and beyond. Furthermore, it should be a supportive factor for the China theme and for the commodities markets in general.
Coincidentally, the CRB index has now reached major price support as it has returned to lows similar to the bottoms in 1975, 1999, and 2001. A bottom in commodities in general reinforces the idea that the gold/copper ratio is topping.
After bottoming out in 1975, the CRB index bounced, pulled back into a slightly higher low in 1977, and then launched a multi-year bull market to historic highs. Similarly, the index bottoming out again in 1999, rallied, pulled back into a slightly lower low in 2001, and then underwent another multi-year bull market that sent commodities to new record highs.
The takeaway here is that the raging bear market in commodities in general has reached a level that could potentially mark the end of the meltdown. If it follows the patterns of 1975-1977 and 1999-2001, commodities would make a sizable bounce in 2016, experience one more sizable pullback, and then it’s off to the races again. This pattern would dovetail nicely with the idea of a reversal in the gold/copper ratio and an improvement in the world economy.
On the other hand, a failure to reverse from here opens the door for the gold/copper ratio to surge another 50%. This would put it in the company of the 1980, 1987, and 2009 peaks at 2.95:1, 2.98:1, and 2.83:1, respectively.
Based on the economic conditions of when these peaks in the gold/copper ratio were established, one would have to consider a continued rally from here to be a bearish omen for the global economy. With commodities already undergoing one of the longest bear markets in history and China, the world’s second-largest economy, sputtering along with the slowest growth in twenty-five years, the prospect of further surge in the gold/copper ratio is downright scary. It would indicate that the straw has broken the economic camel’s back.
Structuring a Spread Position
If you have both the capital and the stomach for trading futures, the simplest way to play relationship between gold and copper is to spread one 100-ounce gold contract against two 25,000-pound copper contracts. You want to have twice as many copper contracts because the nominal value is about half that of gold. Therefore, you create a more dollar neutral position by having a similar dollar amount of gold and copper.
Since the copper contract is priced in cents-per-pound and the gold contract is priced in dollars-per-ounce, you can simplify how the spread is plotted by calculating the difference between the value of the sum of two 25,000-pound copper contracts and the value of the 100-ounce gold contract.
You probably noticed that we are calculating the value of the copper first for the futures spread, which is inverse to how we calculated the gold/copper ratio. The reason for this is because a pair of copper contracts is normally worth more than one gold contract. Therefore, we like to quote and plot the spread where the market that usually shows a premium as the lead. Also, the spread chart will reflect the bearish trend seen in both the underlying gold and copper markets.
If you don’t have the risk capital needed to trade the futures contracts, the ETF market is another way you can trade the copper/gold spread. Be careful with the copper ETFs, though. While there is plenty of liquidity in the gold ETF, the copper ETFs are thinly traded.
The most liquid copper ETF is DJ-UBS Copper Sub-Index ETN (symbol: JJC). It is trading at approximately $23.90. At the same time, the SPDR gold ETF (symbol: GLD) is trading at approximately $102.90. This puts the GLD/JJC ratio at approximately 4.3:1. Therefore, a dollar neutral spread position would require that you purchase approximately four shares of JJC for every share of GLD that is sold short. As you can see, plotting a spread between four shares of JJC and one share of GLD looks similar to the spread between two copper futures contracts and one gold futures contract on the charts.
Historically, the spread between two copper futures contracts and one gold futures contract is in oversold territory once it drops to ‘even money’ or lower (where gold has the premium).
Consider what has transpired the last six times after the copper (x2)/gold spread inverted:
The nearest-futures spread bottomed at -$1,020 (premium gold) in November of 1993. It then rallied for fourteen months into the January 1995 top at +$34,045 (premium copper). The gain was approximately +$35k per spread.
On Boxing Day (December 26) of 2002, the copper (x2)/gold spread bottomed at -$90 (premium gold). It then rallied for a year and one-quarter into the March 2004 top at +$29,765 (premium copper). The gain was nearly +$30k per spread. After several months of consolidation, the rally continued and reached the record-shattering 2006 high of +$136,405.
The 2008 financial crisis crushed the copper (x2)/gold spread. The capitulation point was reached when it breached the 1980 historic low and posted a new all-time low of -$29,380 (premium gold) in March of 2009. From there, the nearest-futures spread began a two-year ascent into the 2011 Valentine’s Day nadir at +$94,965 (premium copper). This rally of +$124k per spread was one for the record books.
The spread inverted again in 2011 and bottomed out at -$8,730 (premium gold) in October of that year. A six-month advance into the April 2012 high of +$28,295 (premium copper) followed, sporting a gain of approximately +$37k per spread off the low.
In November of 2012, the copper (x2)/gold spread dipped just below ‘even money’ and established the bottom at -$815 (premium gold). From there, it worked its way higher into the 2013 New Year’s Eve top at +$51,845 (premium copper). That’s a little over +$52k per spread in thirteen months.
This year, the spread inverted in January. It bottomed out at -$4,615 (premium gold) by the end of the month. This led to a sizable rally into May Day where it topped at +$29,125 (premium copper). The three-month bounce of +$33,700 per spread was certainly an event worth trading this year.
More Food For Thought
We’ve established the fact that the gold/copper ratio is at a potential make-or-break level. We also told you how to structure a position if you want to trade it. Here are a few more things that a futures trader might want to consider when approaching the current situation.
First of all, the gold/copper ratio has reversed from current levels more often than it has broken out. It seems that the way to bet with the probabilities then is to look to trade a reversal. If you agree, you will initially want to get positioned long in the copper and short the gold.
Next, we have to keep in mind that there were a few occasions where the copper (x2)/gold spread plunged substantially below the ‘even money’ waterline before finally bottoming out. This should make a trader bit wary of trying to catch a falling anvil by picking the bottom down here. Look for some sort of evidence of a price reversal. At the very least, make sure the downward momentum is slowing noticeably before jumping in.
From a time perspective, the current inversion is getting quite mature. It has been a little over three months since the copper (x2)/gold spread inverted and there has been no sustainable rallies yet. In the last twenty-five years, the longest period where the spread flip-flopped either side of the ‘even money’ mark before taking off was 4 months and one week. This occurred during the depths of the financial crisis. The other five durations of oscillating either side of ‘even money’ before the train finally left the station was one day (in 2002), one week (in 2012), one and a half weeks (in 2015), six weeks (in 1993), and 2 months and one week (in 2011). From a time perspective, one might think that a turnaround in the copper (x2)/gold spread may be close at hand.
There are three resistance levels I’m currently monitoring for the March-February copper (x2)/gold spread. A breakout of any of them could be used as an entry signal on the long side. They could also be used to scale into a position by entering on the first breakout, adding on a second and raising protective stops, etc.
The ‘even money’ level is an important marker for the spread. The March-February copper (x2)/gold spread closed below this level for more than a week and counting. Therefore, a close back above this level could be a clue that it’s ready to start a move to the upside. It would be kinda like pushing a volley ball under water and seeing it pop back above the surface when you take your hand off.
A rebound from here would be even more compelling since the spread is probing important price support at the January low. Could a double bottom-type formation mark the end of the bear market in the spread? Better yet, how about a Wash & Rinse low (failed breakdown) to trigger program and algorithm selling before it finally makes a sustainable upside reversal?
A close above ‘even money’ would allow the spread to take a shot at price resistance between the similar highs of late September and early November at and +$5,650 and +$5,790, respectively. A breakout above this price barrier would alter the current price structure and add some confirmation to the turnaround.
Finally, the declining 100-day Moving Average is another technical resistance level that you may want to keep tabs on. Since peaking out on May Day and closing under the 100-day MA in mid-June, the March-February copper (x2)/gold spread has not been back above the 100-day MA yet. The bounces in mid-September and early November both stalled out just below this technical barrier. Therefore, a two-day close back above the 100-day MA (currently near +$5,000) would be another indication of a bullish trend change in this spread.
Economic Weather Patterns
Whether or not you trade the spread between gold and copper, the ratio between these metals will still serve as a key barometer for other trades and investments. Traders and investors alike should be paying close attention to how this plays out.
A further surge in the gold/copper ratio and a corresponding collapse in the copper (x2)/gold spread would be reason to seek shelter. A storm is coming. You will likely want to be positioned defensively or short in such conditions. Conversely, a reversal from here would offer a great buying opportunity for traders and tell investors that there are blue skies ahead in the forecast.
The gold/copper ratio will serve as your economic radar, so be sure to check it often. Just like the weather, market trends can change quickly.