Thursday , 25 July 2024

What Are the Implications of the Fall In the Gold/Oil Ratio To Below 20-to-1? (+3K Views)

The gold/oil ratio is recognized as a sort of canary in a coal mine, giving advance warning of turbulence ahead and, for the first time in 3 years, the ratio is below 20-to-1 compared to its historical average of 15-to-1. Were it to go above 20-to-1, making gold too expensive or oil too cheap, and we would be in crisis mode.

The original article has been edited here for length (…) and clarity ([ ])

Spikes in the ratio preceded a number of financial calamities including the Asian currency crisis of the late ‘90s, the Great Recession and, most recently, the Euromarket predicament. The ratio peaked near 47-to-1 in February 2016 when West Texas Intermediate (WTI) crude dipped below the $27-a-barrel level. Since then, the ratio has lurched lower as oil prices have risen and, with WTI now topping $70, the ratio has punched through the 20-to-1 floor.  You can see the ratio’s recent track record in the chart below.

At face value, the gold/oil ratio’s decline could easily be taken as a sign that some sense of normalcy is returning to the markets. Normalcy, of course, isn’t authoritatively defined. Maybe it’s better to say that that the decline heralds a return to normal volatility. That notion seems reasonable given the ratio’s correlation to the Cboe Volatility Index (VIX) as illustrated in the chart below.

In this sense, the gold/oil ratio is an indicator of market sentiment. Still, one can’t ignore the fundamentals at work in the underlying markets: global oil prices are being levered upward by OPEC production cuts and Middle East flare-ups while gold is weighed down by growing prospects of interest rate hikes and a stronger dollar.

I’m betting that there’s a link between the optimism conveyed by the falling gold/oil ratio and the bread-and-circuses fervor expressed in a ratio we examined last week. Is such optimism really warranted or are investors too exuberant? Time will tell…

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