Tuesday, April 29, 2008

The Oil/Gold Divergence

Recently we've seen a great divergence in commodity prices. While oil and most other commodities have continued to rise sharply make new all time high, gold along with silver is trading significantly -more than 10%- below their all time highs reached earlier this year.

As a result, the gold/oil ratio is down to 7.5, down from 10 in mid-March. What, then, is the cause of this? Will this trend continue?

The cause for this divergence is that oil price movements, apart from non-monetary factors, reflect actual inflation while gold price movements mainly reflect movements in inflationary expectations among investors, or to be more precise their demand for gold as an inflation hedge. Actual inflationary pressures remain strong which is the primary reason for why oil has risen so much in price. Meanwhile, gold and silver has taken a beating as demand for them as an inflation hedge has cooled. Instead, many investors have moved their money back into stocks, which can also potentially be an inflation hedge, as inflation also mean that the nominal earnings of companies are inflated.

Will this persist? Well, oil will continue to rise, albeit perhaps briefly interrupted by corrections. Gold weakness will perhaps continue for a while because of the current bearish sentiment, but in a few months or so, it will recover. The reason is that while stocks are an inflation hedge, they are not recession hedges. In recessions their earnings decline. Which is what we've seen despite positive currency effects. And once investors again are reminded about that, they will again move their money out of stocks. And at that point, many will choose the investment object that is a hedge against both recessions and inflation, namely gold.

4 Comments:

Anonymous Anonymous said...

"oil price movements, apart from non-monetary factors, reflect actual inflation while gold price movements mainly reflect movements in inflationary expectations among investors, or to be more precise their demand for gold as an inflation hedge"

I was wondering what was happening with the gold/oil ratio. Thanks for this insight.

5:41 PM  
Anonymous Anonymous said...

But correct me if I'm wrong, gold prices will drop if the fed begins to raise interest rates, as inflation fears settle...

or do people jump from stocks as rates go up and so gold will go up in that case too (assuming rates climb steeply)

12:13 AM  
Anonymous Chui Tey said...

Gold, once extracted, is usually not consumed.

On the other hand, the rate of oil consumption governs the productive output. Therefore, in a world where output is growing, and extractive capacity hasn't grown, you end up with a situation of excess money.

1:26 AM  
Blogger stefankarlsson said...

All else being equal, higher interest rates are bearish for gold as it raises the opportunity cost of holding gold. Money will then move from both stocks and gold to bonds.

However, to the extent higher nominal interest rates reflect higher inflation -or more strictly inflation expectations-, gold will stay strong as people holding bonds will know that the value of their assets are reduced by inflation which will make gold look more attractive.

8:50 AM  

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