Metals markets have performed a dramatic reversal as 2016 nears its close.
Copper, having struggled to post gains all year amid healthy supplies and underwhelming demand, put in its strongest monthly performance since 2006 in November, with three-month LME futures climbing 20 per cent. Gold, which was up as much as 30 per cent in July and heading for its biggest annual increase since 2010, has crashed to a point where it's likely to end the year just $50 or so above where it started.
A simple story has been told to explain this reaction: After the election of Donald Trump, the U.S. Congress is going to take the country off its eight-year fiscal crash diet, push through a $1-trillion (U.S.) infrastructure program and $9.5-trillion of tax cuts, and send economic growth and demand for industrial raw materials such as copper soaring.
Meanwhile, Federal Reserve chair Janet Yellen will respond to the healthier environment by raising interest rates. That ought to increase the attraction of 10-year Treasuries, which should be yielding about 2.8 per cent a year from now, and reduce the appeal of commodities such as gold that pay no interest.
The problem with this theory is that monetary and fiscal policy don't happen in isolation from each other. Put the two stories together, and the narrative starts to look incoherent.
Here's a way to summarize the four situations.
Scenario A is basically what the copper market is predicting. Congress pushes through fiscal stimulus but the U.S. Federal Reserve chooses to hold fire on interest rates. That's consistent with Ms. Yellen's long-standing reputation as a dove and her view expressed this month that monetary policy "remains accommodative."
The problem with that forecast is that the United States represents a rather small share of global copper consumption. A shift in U.S. demand dramatic enough to shake metals markets would stand a good chance of closing the country's lingering output gap and kicking interest rates into a higher gear. In Scenario B, this tighter policy would slow the economy and reduce materials demand. This is more or less what the gold market is predicting.
In theory, it's possible that we get something like Scenario C. Senate majority leader Mitch McConnell last week poured cold water on the idea of a large infrastructure package, and Mr. Trump's "Penny Plan" to cut federal spending will reduce outlays by about $740-billion, according to the Committee for a Responsible Federal Budget, a bipartisan think tank. If fiscal policy wasn't stimulating the economy as much, monetary policy would probably remain loose to compensate.
Scenario D is closer to the situation that's prevailed under most of President Barack Obama's administration. While Congress passed a major stimulus program in February, 2009, nominal government spending has grown at the slowest rate since the Second World War. Meanwhile, interest rates, constrained by the zero lower bound, have spent most of the past eight years tighter than they should be, with inflation as measured by the personal consumption expenditure index falling below the Fed's 2 per cent target in 91 of the 95 months since Mr. Obama's inauguration.
Of those four scenarios, A would match the bullishness in the copper market, but might imply that the current bout of bearishness around gold is overdone. Should scenarios B or D come about, growth is going to be slower than expected and interest rates higher, which would be bearish for both copper and gold. In the unlikely event of Scenario C, copper could fall while gold rises.
There may be edge cases that could explain the recent price action, but in general there are no obvious circumstances in which copper would put in sustainable gains while gold registers ongoing losses, which is what we've been seeing of late.
Anyone making a momentum-type bet on the direction that base and precious metal prices have moved over the past few months should bear in mind quite how unusual their recent behaviour has been. Negative correlations between copper and gold – where one rises, while the other falls – generally hold for only rare, brief periods.
We're in one of those periods at the moment, but wise traders with an eye on history shouldn't count on it lasting. If you're betting on a bullish outlook for copper you'd do well to make the same wager on gold – or vice versa.
David Fickling is a columnist with Bloomberg News.