The Gold:Silver Ratio: Will The Yellow Metal Lose Its Luster?

During the past twelve months the gold:silver (AU:AG) ratio has climbed to and held near some of the highest levels in over a decade, as gold prices shot to record highs and increased risk aversion thanks to the economic downturn, brought capital from riskier assets into precious metals. This somewhat overlooked indicator is now coming into focus more and more, as people begin to wonder are current levels sustainable, or are they signaling a comparative jump in silver is all but inevitable.

The AU:AG ratio is a classic indicator of comparative performance between gold and silver, having been looked at for thousands of years and traditionally fixed by central or government bodies (in ancient Greece for example), coming as a floating rate with the decline of the gold standard and the free market trading of precious metals during the twentieth century.

The rate effectively measures how much silver one would have to sell at any given time in order to purchase one troy ounce of gold, or alternatively, how much silver one could buy if one were to sell one troy ounce of gold. Implicitly, the higher the rate the stronger the comparative performance of gold, effectively its increased purchasing power of silver. Likewise, a lower AU:AG ratio signals comparative weakness in gold (or strength in silver) and the lack of purchasing power for the yellow metal.

So how can we use the rate to assess potential future moves across the precious metals complex? The two primary things we will consider here are where the rate stands compared to historical averages and extremes, and looking at past performance and changes in the metric during and following previous economic downturns. One must also consider that although the ratio is in effect a technical indicator, it is directed by the underlying fundamentals of the two metals, and it is these which will inevitably be the true driver behind the ratio as the world emerges from recession.

During the height of the recent economic crisis in late 2008, the gold:silver ratio peaked at its highest level in four years at 84.4. Just three months earlier, before the world realised the true extent of the economic problems, the rate was hovering around the 50 level, where it had been (plus or minus five points) since the early half of the decade. Looking at this level compared with just about every historical average, the rate was significantly overbought gold, as a flight to safety across the markets pushed the yellow metal to outstrip its industrious counterpart.

Almost inevitably, a natural equilibrium began to resurface during 2009, as the high correlation between gold and silver drove the white metal to benefit in sympathy with gains in gold. Despite this however, the ratio is still seen at relatively high levels compared to historical averages.  Knowing what averages and what constitute ‘extreme’ levels is somewhat contested however, and depends largely on the time period one is looking to invest. That said, the rate currently stands above almost all medium to long term averages (five year average: 58.8, ten year average: 61.7) at around 64, and has in fact only just dipped below the twelve month average of 65.5 this week. While these high levels do not in themselves make a return to trend guaranteed, the very nature of commodities means that devoid of speculation and investment flows, there is an intrinsic value for the physical asset itself, and it is these averages that are allowing us to see historically, how much silver one troy ounce of gold is worth.

The gold:silver ratio also offers us an insight into how the comparative values of the two metals shift during times of recession and economic recovery. Again these are driven by the underlying fundamental factors; however the ratio offers us a clear and comparable measure of the extent and nature of these changes. Looking at previous global recessions over the past twenty years, the AU:AG ratio has rallied during the downturn and seen its apex as the global economy began to recover.

This was the case in the early 1980’s when the rate hit 58, the early 1990’s when it topped 98 and following the tech bubble at the turn of the century, where the rate hit 80. We have now seen this pattern emerge again during the latest recession, and we see the metric pulling-back towards averages as it did following these previous peaks. As a simple measure, the retracement of these previous rallies was around 100% as the global economy recovered, bringing the ratio to almost the exact level it was at prior to the economic contraction. If this is to be the case following the latest crisis, then there is still some way to go in the downside before the rate hits the 50 level it was during 2007. In turn this would of course indicate that gold has some more comparative weakening to come over the next year or so. If we take a look at what drove gold’s outperformance over the past two years, the fundamental picture would appear to mirror this.

One of the primary reasons for gold’s rally during this latest recession was its natural position as a safe-haven asset. When volatility and risk climbed across almost every security, individuals and large investors alike shifted their capital into the relatively stable platform of gold, which historically tends to hold its value. Additionally, this links with another key fundamental factor which allowed gold to top record highs last year; the sharp declines in the US dollar. This helped gold two-fold. Firstly, the inverse relationship between the dollar and gold performance is based on the cost implications to the dollar denominated metal. As the dollar eased off against major currencies, it made the metal comparatively cheaper for investors in Europe, Asia, Australia and all other major industrialized nations. This naturally increased global demand for the metal, bringing about significant gains in the spot price and futures contracts alike.

Although silver also benefits from weakness in the dollar, as does any other dollar denominated commodity, gold has the additional benefit that the greenback is an alternate safe-haven asset. The weakness and uncertainty in the dollar during the recession, as well as the low interest rates imposed by the Federal Reserve, caused investors to avoid using the dollar in their flight to quality and invested it in the only other alternative – gold. This was not only the case with individual investors but also with central banks around the world. Many of these key players in the gold market, particularly China, diversified their reserves by investing in physical gold, attempting to avoid the dollar depreciation.

These factors may explain why the gold:silver ratio shifted in favour of the yellow metal during the recession, but what can we derive about future performance between the two metals?

Firstly, by definition, as the global economy recovers and broader markets begin to stabilize, risk appetite will return back to the market. As the necessity for a safe-haven reseeds, capital will naturally begin to flow away from gold and into the higher volatility securities. Interestingly this is likely to also involve some of these funds moving from gold and into silver, which has always been a higher beta metal; that is to say has a higher volatility and higher price elasticity than the precious metals complex as a whole. Coupled with this and although the outlook for the US dollar is still uncertain, as the American economy recovers the Fed become increasingly likely to raise interest rates once again. When this does eventually come about, the greenback will instantly strengthen as global capital begins to flow back into the US, in turn making gold comparatively more expensive to foreign investors, lowering global demand.

As a final point, it is important to note that this assessment of the gold:silver ratio does not necessarily imply that gold prices will fall and silver prices will climb, but instead suggests that silver will begin to outperform gold. This may mean silver will climb at a higher rate than gold does over the coming year, or it may mean silver remains steady while gold slides back towards previous ranges. Either way, when considering if or where to invest in the precious metals complex, this traditional measurement of performance still has a lot to offer a modern investor.