Since the start of 2020 gold prices have increased by one-quarter, silver prices are up by 50% and the price of palladium up a respectable 14%. What then of platinum, the poor cousin to the other stellar performers in the precious metals space? Down 2.5% year to date!
The expectation by many investors betting on a rebound in platinum prices is that it will eventually play catch-up versus palladium as auto-catalyst manufacturers substitute expensive palladium, for cheaper platinum.
One way of determining whether this is happening is to analyse trade data. Recall from earlier articles on this that in 2010 refiner Johnson Matthey opened a diesel auto-catalyst plant in North Macedonia. Unlike other countries that manufacture catalysts we know that North Macedonia only imports platinum group metals (PGMs) for use in that sector. Any evidence of a substitution effect away from palladium and towards platinum should be picked up in North Macedonia’s import data.
The chart below shows the decline in demand – for both metals – that occurred in the early part of 2020 as the lockdown and frozen supply-chains closed the plant and prevented imports from taking place.
Chart 1: North Macedonia PGM imports(kg)
The second chart is more revealing. Far from there being any sign of a substitution effect away from palladium it continues to show that the trend is gathering force. The share of palladium in total PGM imports even surged to two-thirds in January.
Chart 2: Palladium as a % of total North Macedonian platinum/palladium imports
In the battle to control emissions from the cars of the future palladium remains among ‘the Tesla stock of commodities’.
Newbie precious metal investors suffered a shock this past week. Both gold and silver prices have surged in recent weeks with gold taking out record highs (in dollar terms) and silver breaching levels last seen several years ago. In the space of a few days though gold fell $200 per oz and silver plunged $5 per oz. The catalyst for the drop pinned on an unexpected spike in US bond yields.
It’s worth taking a step back to see how we got to where we are today and what that means for the prospects for gold going forward. For that its worth considering the unique circumstance we find ourselves in, particularly the zero interest rate bound.
2020 marks the first time in history that the yield on both short and long-term US bond yields is near zero. Even in the after the quantitative easing that took place after 2008-09 the yield on long duration bonds was about 3%, versus zero for the short-term. All other things being equal, lower bond yields increase the attractiveness of holding gold. It isn’t just a feature of the US – roughly 80% of global government debt is yielding less than 1%.
The zero interest rate creates some particularly unusual characteristics that influence investor demand for gold. As Bridgewater Associates highlight, inflation and real rates (nominal minus inflation) tend to rise and fall together when rates are sufficiently above zero, but when they are at zero the relationship tends to invert complicating the task of policymakers:
Zero nominal yields also create a unique linkage between real yields and inflation. Because there is an arbitrage between the breakeven inflation rate* and actual inflation, a deflationary downturn that pushes breakeven inflation down is extra risky because the combination pushes real yields up as the economy contracts (because the real yield plus breakeven inflation must equal the nominal yield, and the nominal yield is relatively stable), i.e., you have a higher discount rate on cash flows as cash flows fall. On the other hand, if reflation is successful, central banks will likely delay the rise in nominal yields relative to inflation, forcing real yields to fall. And there is no lower limit to either real yields or breakeven inflation. As a result, a successful reflation can drive real yields much lower even if they start at low levels, and policy failure (i.e., deflation) will drive them higher.
As shown below, Japan has experienced these dynamics since the ’90s. Before rates reached the zero lower bound (marked below with a gray vertical line), inflation and short rates fell and rose together, reflecting the central bank’s responsiveness to conditions. But after rates reached zero, the relationship inverted. Falling inflation, when rates are already at zero, forces real yields higher, producing a tightening as conditions are deteriorating.
* The breakeven inflation rate is the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity.
I’m old enough to remember when central banks actually increased interest rates to head off an increase in inflation. Many will suggest that this time is no different, and that as soon as activity picks up post-COVID and inflationary pressures appear then interest rates will gradually start to pick up.
Given the outsized impact that even tiny amounts of tightening have on the economy and financial systems, every central bank has made it clear that they will wait for substantially higher inflation to be in place for an extended period before considering tightening.
The historical precedent may not in fact be the 1970’s, the most recent period of high inflation. Instead we may have to look back to the 1940’s for guidance. The monetised fiscal expansion that took place in the US after WWII has a number of similarities to where the US and other major economies are today – COVID being perhaps the last of many straws that breaks the back of debt buildup. As the chart below shows, inflation was allowed to rise sharply higher (eroding the real value of post-war debts), and because inflation was higher than nominal bond yields the real yield was negative to the tune of roughly 20% by the end of the 40’s.
In environments like the 1940’s gold and other inflation-protected assets tend to perform well. Gold as an asset doesn’t pay a yield. It’s has zero dividend. But in order to benefit it only has to be better than the alternative, and if the yield on government bonds is zero or negative then it stands to benefit as bond holders move their funds to gold.
The analysis above shows that even if nominal yields rise, inflation is likely to be allowed to increase by an even greater amount. Central banks and indebted governments worldwide really have no other option.
A couple days after the jump in bond yields data coming out of the US showed core inflation (excluding food and energy) rose by 0.6% in July. That might not sound much but its the biggest such increases for almost 30 years.
Gold prices hit record levels this week. That much is old news now. What has escaped the front pages is that another commodity is also nearing record levels. That commodity is lumber.
Record price levels often represent a critical juncture. Either markets push through the resistance and power on, or it all becomes too much and gravity reasserts itself in a spectacular way.
Nevertheless, the relationship between the two commodities offers has offered important insights into the potential return on risk assets. It might pay to watch how each of the commodities plays out over the next couple months.
But first why is lumber important? When we are confident about the future of the economy we are more comfortable making big expensive decisions that are difficult or impossible to reverse. Think of buying a house or a second house even or starting a family!
House purchase activity is an important signal as to the health of the economy – both local and national. It’s not just the cost of the house but spending on all the other things involved with a house; renovation, construction and utilities etc. Together housing represents around one-sixth of the US economy.
A house is by far the largest single purchase that most people will ever make and so it’s an important signal of consumer confidence. Who wants to buy a house when they are worried about where their next pay cheque will come from?
Housing starts are a terrific leading indicator of the US economy. It can take several months for home builders to construct a new property and home builders are reluctant to break ground on new projects if they fear the economy may slump later in the year. Every recession in the US since 1960 has been preceded by decline in housing starts of on average around 25%.
Could there be an even better, even longer leading indicator? Well, the price of lumber is often seen as a leading indicator of the US housing market. Construction companies need to purchase materials to build new houses and the cost of the lumber is a key factor influencing the overall build cost.
If you start to see lumber prices decline sharply and for a prolonged period it typically means that a slowdown in housing starts is around twelve months away. However, as with all market based indicators supply as well as demand influences the price.
Many of you will know that copper and the cost of shipping dry freight are frequently cited as leading indicators of economic activity and demand for commodities. But another indicator that doesn’t get anywhere near as much coverage is the price of lumber in the US, and its relationship with the price of gold.
Research published by Michael Gayed and Charlie Bilello looked at the relationship between lumber and gold prices between 1986 and 2015. According to the research combining cyclical lumber with non-cyclical gold provides key information on when to “play offense” and when to “play defense” in an investment portfolio. Using weekly data available on lumber and gold prices going back to November 1986, the pair developed the following trading rule:
> If lumber is outperforming gold over the prior 13 weeks, take a more aggressive stance in the portfolio for the following week. > If gold is outperforming lumber over the prior 13 weeks, take a more defensive stance in the portfolio for the following week. > Re-evaluate weekly and make changes to the portfolio only when leadership between lumber and gold changes.
From late 2019 and through the first two months of 2020 the price of gold rose at a slightly faster rate than lumber prices. Equity and other markets including commodities fell sharply thereafter as the scale of the impact from covid-19 became clearer. The past two months have seen the roles dramatically reversed with lumber prices up 60% compared with an 11% rise for gold.
Chart: gold versus lumber prices
Gayed and Bilello’s model implies that this means investors should be more aggressive with their portfolio’s, i.e. greater weighting to equities and more small-cap socks for example.
Lumber like many commodity markets has not gone unscathed from the covid-19 pandemic. Many lumber mills were forced to close, or at least severely limit their output during April and May due to social distancing restrictions.
That being said the lumber-gold ratio has been an important bellwether for risk assets in the past despite historical supply disruptions. As both commodities hover near record highs the next couple months are likely to offer an important signal as to the future direction for equity markets.