Keeping an Eye on the Gold/Silver Ratio

by: Evariste Lefeuvre

A lot has been written about the reasons behind the collapse of the Gold/Silver ratio. It presently stands well below its long-term average, and the question of a possible mean reversion remains open. The sharp drop began in mid-2010 when Ben Bernanke announced the second leg of quantitative easing at Jackson Hole (we can also see a relationship with the broad index of the USD - DXY).

The outperformance of silver against gold, whose price has breached the $1,500/oz threshold, suggests that it is becoming increasingly seen as a substitute for gold in the broad context of higher inflation and fiscal long run (un)sustainability. The S&P decision to downgrade U.S. public debt with a negative outlook has reinforced the dollar's weakness. As a result, gold and silver reached new highs.

1. Gold/Silver Macroeconomics

Silver has a hybrid status. In addition to being used to make coins and jewelry (monetary metal), it is widely needed for industrial purposes such as solar cells, cell phones, laptops, and plasma TV (high electrical conductivity). Long-run demand is strong (no cheap substitute) while supply is mostly unpredictable as it is a by-product of other ore extractions. The chart below shows to what extent the ratio is correlated to the outperformance of the Electronic Equipment & Instrument sub index of the S&P 500.

The macro analysis is also explained by the charts below: the Gold/Silver ratio tracks the ratio of CPI (inflation risk, against which gold is perceived to be the best hedge) to industrial production (whose dynamism should propel demand for silver). The 2008 jump is explained by the financial crisis but the relationship seems to be holding so far. Using Core CPI does not change the relationship. Interestingly, the ratio is well correlated with the global PMI: stronger global growth means silver outperformance.

2. Gold/Silver and Hedging

Gold is supposed to provide a comparative advantage against inflation. Yet, the first chart shows that the Gold/Silver ratio is inversely linked to U.S. inflation breakeven. In addition, a falling dollar is accompanied by a retrenchment of the ratio.

The DXY resumed its downtrend and broke below a support at 74.17 (November 2009 low) to hit a 2.5 year low. This paves the way for a return to the major support at 70.70 (March 2008 low), which would definitely be supportive for a lower ratio.

3. Real term analysis

If inflation is a guide, it may be useful in the assessment of the real prices of gold and silver (not in the direction of the ratio). Many investors have been betting on a return to historical highs for both, in real terms. I have doubted the economic relevance of such an argument. However, facts are proving us wrong when it comes to gold prices. As can be seen in the chart, the upward potential for silver is even stronger: a "real target" would be close to $100 an ounce!

4. Squeeze

There are several theories and technical factors for the unprecedented spike in silver prices that has caused the gold/silver ratio to plummet. In conjunction with the increasing demand for silver, it is said that there are several financial institutions with large short positions in silver on the U.S. futures market that cannot be covered by physical stock, which is typical of a short squeeze scenario.

The case for the squeeze explanation should not be ruled out too quickly. The chart above is a simple model of the gold/silver ratio over the last two decades. It is quite well-explained by the S&P 500 (negative beta): a bullish economy is positive for the S&P 500 and therefore an outperformance of silver. When the index drops, gold outperforms as a safe haven. Both DXY and the ratio of CPI to industrial production are included in the model and have the expected signs.

The fit is good and, interestingly, the model failed only once to explain the drop of the index: in 1998 (Berkshire Hathaway)… It does not prove anything in terms of the nature of today's fall, but it suggests that beyond traditional drivers, liquidity shortage (short covering) could explain the recent decline


Even though the explanation is not straightforward, the announcement of QE2 accentuated the fall of the G/S ratio. It might be a simple coincidence, but the impending end of QE2 in June may call for caution.

In the short run, the DXY may continue to fall, which could drive the G/S ratio downward. The risk would be unexpected hawkishness in the Fed's wording, which would be dollar positive, given the overly bearish sentiment that prevails on the USD currently.

In addition, the Global PMI has probably reached its cyclical peak, which is not really bullish for the ratio.

Our model suggests that the current level of the G/S ratio is not justified by traditional drivers. We should not rule out a regime switch, when some players accumulated a massive position in the silver market is not supportive of a continued fall in the medium run.

Using ETF flows to justify the fall of the ratio would be like saying that silver has a relative demand "advantage," which falls short of explaining the causes of the move.

Adjusting the price of both metals to inflation to justify higher prices should not be enough to prop up a strong outperformance of silver against gold.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.