In this study, we challenge the conventional wisdom surrounding the dynamics of gold prices and fluctuations in the oil market. We found that there is no clear evidence of a relationship between oil and gold prices in the long term. The reason is that participants should look at the long end of the oil curve, which, unlike the short end, is much less volatile and is considered to be an important driver of gold, with expectations of real rates.
We remain optimistic about gold (GLD) in the long term against the backdrop of massive central bank liquidity injections, combined with the risk of growing global political uncertainty due to sharp increases in unemployment rates . But a drop in the long-term oil curve could increase the selling pressure on the precious metal in the short and medium term.
The strong divergence between gold and oil
Since the beginning of the year, the price of oil has dropped by almost 70% and many analysts wonder if black gold has found its lows at $ 20 a barrel. We believe the oil shock alone would have plunged the world into a mild recession, but uncertainty over COVID-19, in addition to the global blockage, will severely affect world GDP in the first half of this year. Figure 1 (left frame) examines the year-over-year price of oil (3M lead) with annual growth in real US GDP over the past 35 years. It can be noted that the oil shocks (40% + drops in oil prices) generally led to a noticeable drop in growth or to a recession.
Unlike the great financial crisis of 2008, the COVID-19 crisis is a supply shock that will spill over into demand in the coming months; the closure of most small and medium-sized businesses should lead to unemployment rates in unexplored territories in most G20 economies, leading to a drop in consumption. On the basis of different calculations, it is fair to say that almost 15% of the world GDP of the advanced countries will be lost this year and most certainly in 2021.
On the other hand, gold, the other most traded commodity, has constantly reached new heights in recent months amid growing fears of a collapse of fiat currencies due to massive injections of cash central banks and other large institutions. In our previous article on gold, we saw that the price of gold is strongly influenced by interest rates, inflation, stock prices and central bank reserve policies (Baur, 2013) .
Gold is also considered to be a zero beta asset which tends to remain solid in times of sharp equity declines; for example, while US stocks (SPY) have been down 16.2% since the start of the year, gold (GLD) is up 8.5%. In recent years, we have also seen that the GLD was significantly influenced by the amount of negative yield debt in the world (Figure 1, right frame). Like many alternative (exotic) assets, gold has no fundamental value and investors only benefit from price appreciation. So, in a ZIRP / NIRP world, an increase in negative yielding debt clearly indicates negative sentiment in the markets and pushes the precious metal to higher levels against all currencies. With the exception of the Swiss franc and the US dollar, gold is trading at record levels against all other major currencies.
We believe that the current pace of monetary policy followed by a surge in political uncertainty amid massive waves of global unemployment will support GLD in the long term, returning the precious metal to the September high in US dollars.
Source: Eikon Reuters, Bloomberg
However, there are two main risks that gold could face in the short term, the market experiencing a new wave of sales in a context of drastic deterioration in economic fundamentals. The first is that a stock sale could force some investors to sell their position in gold to meet margin requirements or to raise cash to finance their short-term obligations; this could produce a downward momentum as we saw between March 6 and March 20. Gold fell more than 10.5% during this period, its largest decline since 1982 (Figure 2, left frame).
The second risk, which we are going to develop today, is the decline in long-term oil futures, which would flatten the entire downward curve.
Even if a significant part of the oil curve has flattened in recent weeks, the movements have been much more drastic at the start of the curve. Figure 2 (right frame) shows the slope of the curve between a 3-year futures contract and the one-month contract; we can notice that the curve is currently deep in the contango after moving backward for most of the year in 2019. It is even deeper in the contango if we look at the longest end of the curve, because the 10-year futures contract is traded above $ 50 a barrel (more uncertainty on the price because the liquidity of the contract is very low).
Along with real interest rate expectations, the oil futures curve is an important factor which stimulates the dynamics of gold in the medium term.
Source: Eikon Reuters
Oil and gold: the intuitive relationship
In addition to the popular gold-to-silver ratio that many analysts have observed over time, the gold-to-oil ratio (GOR) has also hit the headlines in recent weeks. Figure 3 (left frame) shows that the GOR has co-moved strongly with the VIX over time; Oil and equities have shown an important relationship over the past 15 years, so a regime of high volatility is generally negative for oil and positive for the asset at zero beta: gold. Figure 3 (right frame) shows that if gold is the ultimate hedge against high price volatility (with US Treasuries and the JPY), oil behaves very poorly in times of a rising VIX. Since 1990, it has posted an average of -106 basis points per month when VIX traded above 20; on the other hand, gold has on average 63 bp.
Source: Eikon Reuters, RR calculations
In theory, if you think of gold as a hedge against inflation, an oil shock should be negative for gold, since you expect inflation to start dropping dramatically over the months following. Figure 4 (left frame) shows the relationship between the annual change in oil prices and inflation in the US CPI. It can be noted that a sharp drop in oil is generally followed by a fall in inflation three months later. Measures of market-based inflation expectations such as the inflation swap 5Y5Y are also very sensitive to oil price shocks, as we can see in Figure 4 (right frame). Shouldn’t a sudden drop in long-term inflation expectations be negative for the price of gold? We have repeatedly argued that, as the products of market-based inflation expectations are sensitive to energy prices, this represents more of a demand for hedges against inflation than of future prospects for inflation expectations. ‘inflation. In theory, long-term inflation expectations should not be influenced by a sudden drop in oil prices, as better monetary policy readjustments will offset the shock.
Source: Eikon Reuters
Evidence for a long-term relationship between gold and oil is unclear
Since gold and oil are the main representatives of the commodity market, we will first verify the existence of a cointegration between the two time series. Previous studies have shown that we have previously experienced periods of constant trends between gold and oil with a strong positive correlation, such as the 2000-2008 sampling period. However, many relationships between gold and certain financial variables such as the USD, oil and stocks were affected by the great financial crisis.
For this study, we use monthly data on the spot prices of gold and the WTI month futures contract since 1990. In order to first verify whether each time series (in logarithmic terms) are variables I ( 1), we execute Augmented Dickey-Fuller (ADF) tests the two variables that we differentiate once and checks if the critical value is lower than the calculated value (t-stat). The results are shown in Figure 5; the two differentiated time series are stationary, which implies that oil and gold are both I (1) variables.
However, when we next verify the existence of a long-term equilibrium relationship between the two markets, we find no evidence of cointegration. Using the classic two-step Engle-Granger method, we first examine the following OLS regression:
We find that the coefficient is equal to 0.83 (beta_hat), but we cannot conclude anything because the residues are not stationary. It is important to always verify the second step of the method by running an ADF test on the residues.
If we now include a breakpoint in our study, we also get statistically and economically intuitive results (see Figure 6). The breakup occurred in the last quarter of 2008 (during GFC), as the relationship between a large number of assets changed considerably before and after GFC. This time, the residues are stationary, which would imply the existence of a cointegration between gold and oil. However, we can notice that the R_2 is very high and that the Durbin-Watson statistic is very low (close to zero), which raises concerns about parasitic or nonsense regressions in the time series. This usually happens because time series is dominated by smooth, long-term trends, and so such empirical evidence tells us little or nothing about the relationship between gold and oil.
Are changes in oil prices causing changes in gold?
In this section, we regress the variations in gold prices on the lagged variations in oil prices. As we mentioned earlier, oil prices tend to drive inflation, and therefore we expect gold prices to experience some selling pressure as inflation begins to decrease significantly over the next few months. We are looking at different lag periods for oil, from 1 month to 1 year. The results are shown in Figure 7. Note that the regressions are run separately each time.
We note that none of the coefficients is significant at a level of 10%. Therefore, we cannot infer anything from these regressions.
The long term matters most
However, we do know that the short end of the oil futures curve can be quite volatile and generally responds to a variety of factors in the market. Figure 8 (left frame) shows the dynamics of the WTI futures contract for the first month since the beginning of this month (April); in the past 10 days, the WTI has gone from $ 20 to $ 29 and is now trading at $ 23 per barrel following the disappointing announcement from OPEC +.
The long term is much less volatile. Figure 8 (right frame) shows the future curve for WTI today compared to early January this year; While the contract for the first month is down from $ 40 to $ 23 per barrel, the long term has remained stable, with 10-year futures still trading at $ 50.
We believe that a sudden drop in long-term futures will then start to matter for all commodities, including gold. A drop in 5 and 10 year futures will flatten the oil curve, but will be seen as a “bear flattening” implying a significant drop in demand over the longer term.
Source: Eikon Reuters
Figure 9 shows the relationship between GLD and WTI 6Y futures prices over the past 15 years. We can note that the volatility of LT futures is much less than the WTI spot prices and that the sustained period of weakening oil prices between 2010 and 2016 affected the entire spectrum of commodities and has also led to a bearish momentum for gold. The 10-year futures contract is even more sticky, which would reduce the divergence we have observed between the two assets in recent weeks.
Source: Eikon Reuters
We are convinced that the current monetary regime, in addition to the risk of growing political uncertainty in the world amid massive unemployment, will support the precious metal in the long term. As many practitioners have brilliantly exposed, gold offers significant diversification and protects investors when stocks fall.
However, we would carefully watch the long end of the oil futures curve (10-year contracts), as a “bear flattening” in the current deep oil contango curve could potentially increase selling pressures on gold. Inflation risk is high (i.e. positive for GLD), but global uncertainty may push large numbers of households from consumers to savers in the coming month, thus lengthening the duration of the deflationary shock . Buying gold at current levels may indeed be too early, therefore we could have period consolidation as we experienced in 2008 (30 percent contraction from peak to trough).
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Disclosure: I am / we are long USDJPY. I wrote this article myself and it expresses my own opinions. I do not receive any compensation for this (other than from Seeking Alpha). I have no business relationship with a company whose actions are mentioned in this article.