A Flashing Light Grows DimThe gold-to-copper ratio (GCR) is a reliable indicator of market stress. The GCR is the price of gold in U.S. dollars divided by the price of copper and answers the question, “how many pounds of copper can I buy with an ounce of gold?” During periods of market stress, gold price typically rises as copper prices decline. In turn, the GCR increases - spiking when things get really scary.
The second chart shows the gold-to-copper ratio over the same time period as the first. The value of gold relative to copper has trended higher (purple dashed line) and every copper price correction (shaded boxes) has included one or more GCR spikes. It’s noteworthy that an ounce of gold in mid-2006 fetched only 200 pounds of copper. As October 2015 comes to a close, an ounce of the yellow metal buys 490 pounds of the red. A July 2016 projection shows an increase to 510.
The trend line represents a relative “fair value” for the two metals – gold and copper at price equilibrium. If the GCR rises above fair value, gold trades at a premium to copper; if the GCR falls, gold trades at a discount. Gold priced a discount prior to Lehman Brothers and correction spikes tended to only reach fair value. Post-Lehman, gold rallied not only in U.S. dollar price but in premium relative to copper. During the mega-crash, the GCR peaked at 578 pounds per ounce. This was followed by a larger spike of 621 as copper recovered from its bottom and gold popped above $1,025 in February 2009.
Since spikes occur during market stress, the difference between peak and fair value can be viewed as a “fear premium.” Importantly, the fear premium has been in decline for the four corrections following the big crash of 2008. During the last correction in August, the GCR peaked at 517, only 30 pounds per ounce above fair value. In the 2008 mega-crash, the fear premium at 270 was a whopping nine-times larger.
A slowing China in combination with the end of U.S. quantitative easing pushed copper below the $3-floor – what was once support now becomes resistance. As the Federal Reserve contemplates tightening with rate increases on the near horizon; Japan, Europe and China are loosening their monetary policy to stimulate growth. This central bank divergence has ushered in a strong U.S. dollar placing downward pressure on dollarized commodities. Gold faces the additional challenge of rising interest rates in a low inflation environment.
The GCR chart suggests that much of the post-Lehman angst has left the metal markets on a comparative basis. In the summer edition of Mining Quarterly, I predicted 2015 gold would trade in a range of $1,100 to 1,200 for the second half of 2015 with rising commodity prices slowly closing the value gap. Comex gold ends October at $1,141 per ounce trading very near fair value with the red metal - the value gap for copper has closed. A rising GCR fair value in 2016 may cause gold to trade at a discount, not premium, to the red metal. Adjusting for a probable discount, my first-half of the year gold range is $1,060 to $1,160. A rise in inflation expectations or geopolitical shock could move the top number notably higher.
There is building consensus that copper demand will revive by 2017. In the meantime, mining giants such as Glencore and Freeport-McMoRan are cutting production to stabilize prices. Given these factors, the August low may indeed be shouting, “It’s over!” My 2016 copper price outlook is for stable trading ranges above $2.20 per pound but below $3-resistance. The coming year will be a transition period that likely avoids the 2008 $1.5-copper lows and a second famous Yogi-ism, “…déjà vu all over again.”