The Hindu Business Line : <I>Why gold prices move ahead of metals </I>

Liquidity has been one of the main drivers of the current commodity market price cycle, and especially so in the precious metals segment. With interest rates rising, concerns have arisen over the impact a tighter monetary may have on commodity prices.

Although nominal interest rates are relevant for financial markets, inflation adjusted real interest rates are arguably more important as they capture the true funding costs. Generally real interest rates and gold prices are inversely related.

According to experts, there is the interplay of the real economy and the financial markets. For instance, when economies are expanding, upward pressure on general prices persists. In an effort to slowdown growth, central banks start to increase interest rates.

However, although monetary authorities raise nominal funding cost, real interest rates may still be falling and even turn negative owing to inflationary pressures (which has been the case in the current cycle, assert experts) and this keeps the cost financing investments (such as gold) low.

Expectations

In addition, as real money costs remain low, market participants may raise their inflation expectations. This leads to additional gold demand as the metal is used as hedge against inflation and a store of value.

How are gold and base metals related? Gold prices often move ahead of base metals prices. According to Macquarie Research Commodities, statistical tests show a strong correlation between gold and LMEX at a high 0.79.

The results of Granger causality tests, which show the direction of causality, reveal it is 99.95 per cent probable that gold Granger causes LMEX (that is changes in gold prices cause changes in LMEX).

One way to explain the causality, according to Macquarie, is that base metals prices react more closely to the balance on the physical market, which is strongly related to economic growth. In other words, as industrial production and metals consumption rises, the market moves into deficit and this pushes prices up.

On the other hand, the balance on the physical market is largely irrelevant for gold prices, which are more influenced by financial and general macro-economic variables such as exchange rates, interest rates and inflation.