Why the Copper/Gold Ratio is So Important to Traders
Aug 23, 2023
The copper/gold ratio, calculated by dividing the price of copper by the price of gold, serves as a valuable tool for traders and economists. It illustrates the relative value of copper (/HG) against gold, (/GC).
Copper, indicative of industrial demand and economic activity, stands in contrast to gold, a safe haven asset with limited industrial use. The copper/gold ratio serves as a comparison between an industrial demand asset and a financial asset. This comparison provides unique insights that can be deduced by analyzing the direction of the ratio. Notably, it is a leading indicator for Treasury yields, a topic we will delve into later.
When there are expectations of an economic contraction, copper prices usually decline, while gold prices ascend. If gold's price increases at a faster rate than copper or falls at a slower pace, the ratio diminishes. Conversely, the ratio escalates when copper's price rises more rapidly than gold.
The chart below represents the copper/gold ratio as the price of copper per pound divided by the price of gold per ounce. While some prefer to calculate it on an ounce-vs.-ounce basis, the absolute value of the ratio is not the primary focus. What truly matters is the direction of the ratio and its divergence or convergence with Treasury yields.
The most recent multi-year high for the ratio was observed in October 2021, following a nearly two-year rally from a multi-decade low in April 2020. During this period, the ratio surged over 100%. However, since that October peak, the ratio has been on a downward trend.
The ratio's behavior as an economic indicator is logical, given that copper prices have dropped approximately 20% since then, while gold prices have risen by 13%. This indicates a slowdown in the global economy, a phenomenon we've seen reflected in economic indicators as higher interest rates permeate the economy.
Historically, the ratio has been a fairly accurate leading indicator for Treasury yields. This is primarily due to bond traders buying during times of economic distress, which drives yields lower, and selling when the economic outlook is positive, leading to a rise in yields.
So, should we declare a peak in yields because the copper/gold ratio is suggesting so? Firstly, it's crucial to identify some of the driving factors for bonds that might be causing this divergence. There's uncertainty in the market about whether the Federal Reserve has finished hiking rates. The supply of Treasuries through upcoming auctions is expected to increase as well, which may support yields.
However, if the Fed were to back down and rates top out at 5.00%-5.25%, that would likely signify the peak in yields for this cycle. In this case, the copper/gold ratio would once again prove to be a reliable leading indicator. This is my personal base case scenario. The implications would be favorable not only for yield-sensitive gold (GC) and silver (/SI), but also for equities such as Nasdaq (/NQ), S&P 500 (/ES), and Russell 2000 (/RTY).
Thomas Westwater, a tastylive financial writer and analyst, has eight years of markets and trading experience. @fxwestwater
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