Concerning Relationships

by Rob Kirby, Kirby Analytics. May 2, 2005

With European markets being closed today in observance of May Day celebrations, markets are expected to be thin and trading volumes light. As this piece is being written on Sunday evening for publication for Monday's wrap up, I can report that the dollar is firming modestly against the currencies with the precious metals complex showing softness, with gold futures off 1.70 and silver up .01 at the time of writing. Much has been written, over the course of time, concerning long running relationships between commodities in general and specific commodities or financial products in particular. These long held relationships warrant frequent repeating and close monitoring in uncertain times, with breaks from traditional ranges often serving as harbingers of larger impending moves in the products or commodities in question.

Dollar Vs. Gold

One of the most often reported of these relationships is the observable inverse relationship between the value of the dollar and gold. This relationship is often cited in the stalwart technical work of Mr. Jim Sinclair and most recently a comprehensive treatise was composed by Mr. Nick Barisheff right here at Financial Sense. It is useful to take note that the dollar and precious metals are generally viewed as the mirror image of each other - meaning the greenback usually advances when gold and silver sell off and visa versa. This relationship between the precious metals and the dollar has a long history dating back to the early 1970s when President Nixon closed the gold window taking us off the gold standard.

Gold Vs. Oil

There are other historic relationships in financial land that warrant close scrutiny. One such relationship is the gold – oil relationship.

Compliments of Adam Hamilton: zealLLC.com

Thanks to the chart above, compliments of Adam Hamilton, we can clearly see that the currently gold/oil ratio is currently trending towards its all time lows at approximately 8 barrels of oil to one ounce of gold. Using the past as a guide, a reversion to the mean [a number closer to the 15 or 16 levels in the chart above] is likely in order. This is highly suggestive that currently - either oil is too expensive or gold is too cheap - or perhaps a combination of the two?

Gold Vs. Silver

The gold vs. silver ratio is closely watched by participants in the precious metals arena. Its daily fluctuations can be readily viewed at Kitco's all metal quotes page.

XAU and GOLD RATIOS
	May 02, 2005 01:25 NY Time
	XAU	83.52	+1.39	Gold / XAU Ratio	5.18
	Gold / Silver Ratio	62.89	-	Gold / Platinum Ratio	0.50

Data compliments of: kitco.com

In modern times, the gold/silver ratio has fluctuated in quite a wide band from about 15:1 - 100:1 - [currently at 63:1 in the chart above]. For investors looking to gain exposure to gold and silver bullion - without taking cumbersome delivery themselves - for their investment portfolios, it might be prudent to understand this ratio. Here's why: All exchange traded bullion funds are not created equally. For example, the exchange traded fund [ETF] - GLD is an open exchange traded fund but its units derive their underlying value form the futures price of gold bullion exclusively. Other exchange traded bullion products, like the closed fund - Central Fund of Canada [CEF.NV.A] or Millennium Bullion Fund's mutual fund trust product offer investors the opportunity of diversity buying segregated [fully audited] gold, silver and even platinum conveniently with the purchase of one product. When purchasing these products, understanding the concentrations [ratio] of each particular metal helps one to not only understand what it is they've bought, but the unit’s corresponding price move[s] over time.

CRB Index and Gold

The continuous chart [below] of the CRB index superimposed over a chart of the price of gold:

Compliments of Dan Norcini

shows a very high degree of correlation over the past 25 years. For those who may not be aware, the CRB index is a broad measure of inflation and an alternative to more widely known measures such as the consumer price index [CPI] or the producer price index [PPI]. Will this highly correlated action continue? Hard to say – but it bears watching.

Government Vs Corporate Bonds [a.k.a. Credit Spreads]

Just like all funds that trade on recognized exchanges [open vs. closed] are not created alike, all rated bonds are generally known by how credit rating agencies like Standard & Poor's or Moody's Investor's Service view their creditworthiness. These agencies classify debt issues, usually by letters A, B or C according to their own ongoing due diligence regarding the financial position of the issuer.

BBB and above credits are deemed by most institutional investors to be of investment grade. BB rated debt and below is generally referred to as "junk bond" status. Many institutional investors, be they pension funds or mutual funds, have articles written right into their charters dictating strict limits as to the amount, if any, of junk rated debt they may hold in their portfolios. This is why issuers of debt are generally so concerned about their credit ratings; the higher their credit rating, the greater appeal their debt has to the widest pool of potential buyers of debt – hence lower borrowing cost.

Government or sovereign debt of developed countries in the Western World usually receives the highest credit ratings [AA or AAA – depending on the agency] from the ratings agencies - so long as they are issuing in their own [domestic] currency. Credit ratings agencies are inclined to view sovereign borrowers in this light since they typically have the exclusive rights to effect laws regarding taxation in their jurisdictions. If all else fails, sovereign entities can typically either directly print or instruct their central banks to print enough money to meet their obligations. They are most wary of doing this, though, as the obvious implications are detrimental to their future access to foreign capital. Countries that borrow funds in currencies other than their own sometimes can experience deterioration in their foreign currency credit rating. This stems from the fact that countries can only print their own currency and tax within their own borders. Corporate borrowers who achieve junk status, on the other hand, typically pay stiff premiums to the highest grades of debt which may range from a few basis points to hundreds or even a thousand or more basis points premiums to attract funds.

With sovereign debt serving as a "benchmark" at the apex of the debt pyramid, corporate issues are typically priced with the same "letter method" with subsequent "grades" representing dynamic premiums [they are subject to movement], measured in basis points, above the corresponding benchmark duration. As such, a 2 year corporate bond may be said to be "trading" 12 basis points above the benchmark 2 year government bond [so if the yield on 2 year governments was, say, 3.25 %; the 2 year corporate paper would be seen at 3.37%]. In trading parlance, this 2 year corporate bond would simply be said to be worth "twelve over".

As a general rule, when the economy is buoyant and expanding - company's prospects are generally viewed to be "looking up" - all things being equal. When these conditions exist, cash flow available to service debt generally expands. As such, company's perceived ability to service existing debt is reinforced and spreads over government maturities in the credit markets contract. Cheaper access to funds often results in increases in planned capital expenditures on the part of companies to meet increased demand resulting from the economic expansion. Cheap or easy money in its extreme is usually said to be inflationary and lends itself to the creation of asset bubbles.

When the economy worsens or slows down, the process works in reverse. Company's prospects to service debt suffer through restricted operating cash flows - corporate spreads tend to "widen" or blow out from the corresponding government benchmarks. he resulting increased cost of credit now curtails planned capital expenditures as companies consolidate operations in preparedness of a slowing economy. In its extreme, this situation is referred to in markets as a credit crunch and is historically accompanied by deflationary pressures in the economy.

To trained and observant financial markets participants, the movements in these credit spreads outlined above, offer clues as to the future direction of the economy as a whole. When credit spreads "blow out" market watchers tend to start reigning in their forecasts for economic growth going forward and the resulting reactions in the foreign exchange and equity markets can be very pronounced and sudden - particularly if one of the aforementioned asset bubbles happens to "pop".

Of late, companies such as Fannie Mae [NYSE: FNM] and General Motors [NYSE: GM] have been in the news with much attention focused on their bond ratings and lots of discussion as to whether or not GM's credit rating may be downgraded to "junk" status. This becomes relevant due to the fact that GM is an extremely large issuer of debt through its GMAC finance arm to the tune of 200 - 300 billion in aggregate. A downgrade to junk status could trigger large amounts of selling of GM bonds. This could have seriously negative systemic repercussions in the financial markets should a too rapid divestiture occur.

This is why relationships are important, folks, so let's make sure we all pay attention to the ones nearest and dearest to us.

Today's Market

With European markets closed in observance of May Day celebrations, overseas market trading activity was muted. Japan's Nikkei Index finished the day down close to 7 points at 11,002.

The Dow finished the day up 59.19, at 10,251.70, the NASDAQ closed up 7 at 1,928.65 and the S & P finished with gains of 5.31 closing the day at 1,162.

Bonds finished the day virtually unchanged with the 10 yr. note at 4.20% and the 5 yrs. two basis points better at 3.88%.

The Dollar Index as measured by the USD closed up a fractional .03 to 84.45 with the Yen closing at 105.06, Euro at .7773, the GBP at .5278, the CAD at 1.2550 and the Ruble finishing unchanged at 27.78 as the Russian market was closed in observance of May Day celebrations. NYMEX crude oil finished the day up 1.20 at 50.92.

Precious metals finished the day sharply lower with COMEX gold closing down 5.60 at 429.30 and silver off .06 at 6.83. The XAU gold bug index finished the day virtually unchanged up a fractional .14 to 83.65, while the HUI closed down .96 at 177.07.

On the docket tomorrow, we anticipate March Factory Orders at 10:00 am - with a consensus estimate of -1.3%. vs. previous +.2%. At 12:00 pm we expect the release of April auto sales numbers [expected 5.3M units] as well as April truck sales [expected 8.0M units]. At 2:15 pm we expect to hear the Fed. Open Market Committee's [FOMC] decision on short term interest rates. They are widely expected to raise their target for Fed Funds - to 3.00%.

Have a great evening and a pleasant tomorrow.

Rob Kirby

Contact Information

Rob Kirby | Proprietor, Kirby Analytics Newsletter - Proprietary Macroeconomic Research
Toronto, Ontario, Canada | Observations | FSU Editorials | E-mail