Oil/Gold Ratio

Useful correlations to US CPI and US 2s10s

The oil/gold ratio is something I’ve used to gauge inflation, and inflation expectations. That is, if oil is outperforming gold, we should begin to see inflation; and if gold is outperforming oil, we should begin to see disinflation.

Initially I used the oil/gold ratio as one input into my 10y Treasury model, as it has about a 60% correlation to Treasuries.

Green line – Oil/Gold ratio

White line – US 10y yield

The idea to then apply the oil/gold ratio to the US 2s10s curve came from the book “Currency Trading and Intermarket Analysis” by Ashraf Laidi. He described the ratio in the context of both the yield curve cycle, as well as using the ratio to indicate rate hiking and cutting cycles. This is based on the view that as oil outperforms gold, it becomes a drag on the economy, therefore the Fed will have to stop hiking and begin cutting. The ratio begins to roll over before the cut’s generally begin, giving you plenty of warning.

The correlation between Oil/Gold ratio and US 2s10s is almost 80%.

Orange line – Oil/Gold ratio

White line – US 2s10s

Given it’s usefulness as an inflation indicator with respect to bond yields and the curve, the next logical step is to look at how the ratio corresponds to actual CPI, and to see if it can give us some sort of useful info.

From the chart below we can see the ratio leads turns in CPI occasionally, but is generally coincident. However, given we get a ‘real-time’ feel for inflation prior to the monthly prints, it still is useful. In fact, the ratio is 66% correlated to CPI with an R-squared of 0.44.

Green line – Oil/Gold ratio (multiplied by 100 to get better granularity)

White line – US CPI YoY%

The recent correlation between them seems to have dropped somewhat, however looking on a shorter time horizon (the above chart is the last 20 years) still shows a decent relationship. As a side note, the overall lower ratio compared to pre-crisis shows you why inflation has been so sluggish in the US.

More to follow on this, but the below shows a CPI model I’ve put together using a couple of different iterations of the oil/gold ratio. This model has a correlation to actual YoY CPI of 73% with an R-squared of 0.54.

Yellow line – CPI Model

White line – CPI YoY