Gold and commodities

Nov 22, 2013·Alasdair Macleod

The relationship between gold and commodities is essentially a simple one. If you look at long-term charts of oil priced in gold for example, you find that they have been more constant than oil priced in paper currencies. In 1965, gold was at $35 and oil was priced at $2.90 per barrel, so priced in gold oil was 0.083 ounces. Today gold is $1250 and oil is $95, so oil is 0.076 ounces. Therefore the price of oil in terms of gold has hardly changed over nearly forty years compared with it rising 33 times measured in US dollars.

What has happened is the purchasing power of the dollar has fallen. Since 1965 the quantity of gold in above ground stocks has doubled, which other things being equal explains a rise in the price of oil in gold terms. At the same time, the Fiat Money Quantity (a measure of total dollar cash and deposits in the banking system) has increased 33 times, which again is broadly consistent with the price of oil measured in USD increasing substantially.

There are significant fluctuations in price from the oil side as well. Before the Lehman crisis in mid-2008, oil peaked at $140 before collapsing to under $40by the year-end, or in gold terms, 0.14oz to 0.05oz, so there is no precision in these relationships. However, so long as economic conditions are roughly stable, over time it will be true that gold, in paper currency terms, will tend to move in line with commodity prices.

For this reason many analysts make the mistake of tying gold closely to the general commodity cycle. This trend assumption ignores the monetary role of gold at a time of great currency inflation and systemic risk. It is hardly surprising, since so far as I'm aware not one commodity analyst even considers the possibility that changes in commodity prices might be due to changes in the purchasing power of the currency.

For this reason, they will either use technical analysis or will focus on prospective demand for commodities in the light of the global economic outlook. Both these approaches are inherently subjective.

The monetary situation today is at an extreme for which the consensus is not prepared. Let us take two simple facts: governments are being funded by their central banks at wholly artificial interest rates; and the global banking system, exposed to government bonds, interest rate swaps and highly-indebted customers, would face a renewed crisis if interest rates and bond yields were suddenly normalised.

Not only has there been significant deviation between gold and commodity prices in the past, but the past is no guide to the current position. Currency inflation is now a significant and escalating problem, and those that think gold will continue to act like any other commodity are almost certainly mistaken.