In a note on the role of gold as a "geopolitical hedge of last resort", Goldman chief commodities strategist, Jeff Currie, writes that while it is tempting to blame the rally in gold prices on recent events in North Korea - which have certainly helped create a bid in gold - they only explain a fraction, or ~$15/oz of the more than $100/oz rally since mid-July. Instead, Goldman finds that the events in Washington over the past two months play a far larger role in the recent gold rally coupled by a sharply weaker dollar.
Currie writes that Goldman's market strategists have found that Trump’s approval rating is a good proxy for this "Washington risk" with a high correlation to both interest rates and gold prices (see Exhibit 1).
Goldman also notes that the Trump risk premium is reflected in both real interest rates and a weaker US dollar account for 85% of the price movement in gold prices this past year.
So what about the risk, or threat, from a North Korean escalation, potentially culminating with a nuclear exchange? Here Goldman is more skeptical about the causal linkage between the growing risk level and the price of gold.
The view that North Korea is a stable equilibrium is consistent with a lack of a large North Korean risk premium in gold prices and consistent with the history of gold prices. While gold has acted as a call option on extreme geopolitical events such as the Gulf Wars and other tail risks in the past, on average it doesn’t respond to geopolitical risk after controlling for other macro variables, such as real interest rates and the US dollar. We find that gold is a good hedge against geopolitical risks when the event leads to a debasement of the dollar. More broadly, we find that oil is a better geopolitical hedge historically given that oil producers such as Iraq, Iran, and Russia have been at the center of most geopolitical risks since the early 1970s. Clearly, this is not the case with North Korea, which leaves gold as the best option to hedge the current geopolitical risk.
Although events in North Korea are very serious, the lack of a large North Korean risk premium suggests that the market views military escalation and disarmament as still very much tail risks. This is a classic Nash equilibrium where no one can gain by a unilateral change of strategy if the strategies of the others remain unchanged. North Korea may not really have an incentive to launch an attack as this would likely lead to retaliation. But it is also unlikely to give up nuclear capabilities as it likely sees them as a guarantee of its safety. As a result from game theory perspective it is a stable equilibrium.
So if gold isn't rising on North Korea, what is it rising on, and just what risk does gold hedge? Goldman's "short answer" - currency debasement typically resulting from a central bank printing money.
This dynamic is captured by a negative correlation between gold prices and real interest rates. As the central bank prints more currency, the price of the currency as measured by the real interest rate declines. The lower real interest rate, in turn, reduces the opportunity cost of holding a real asset like gold, leading the market to bid up gold prices. So at the core, gold is a hedge against debasement, which is why we have termed it the “currency of last resort.” This also explains why gold can be a good inflation hedge but is not always one. If debasement leads to inflation, then gold will serve as an inflation hedge. But as we saw over the past decade, debasement doesn’t always lead to inflation, and is not the only source of it, either.
That said, Goldman is not so naive to uniformly claim that gold does not serve as a hedge to geopolitical risk: it does, as several historical precedents demonstrate:
We find that gold can effectively hedge against geopolitical risk if the geopolitical event is extreme enough that it leads to some sort of currency debasement, and especially if the gold price move is much sharper than the move in real rates or the dollar. For these events, gold essentially serves as a call option and can therefore be thought of as a “geopolitical hedge of last resort.” For example, gold served as an effective hedge after the events of September 11, 2001 when the US Federal Reserve substantially increased dollar liquidity, debasing the US dollar. Gold also proved an effective hedge during the Gulf Wars as governments printed money. That said, it is interesting to note that the oil supply disruptions created by Gulf War I led oil to act as a better hedge than gold, which has been the case during several geopolitical events centered around oil-producing nations. However, during Gulf War II, when supply disruptions were minimized, gold acted as the better hedge.
Risk and response
Finally, there is the issue of liquidity, which in a full-blown conflict will likely collapse for all assets, including gold... with one exception.
This analysis, however, doesn’t take into consideration gold-market liquidity itself, which can be crucial when deciding to hedge via physical gold in a vault versus COMEX gold futures. Using a gold futures contract as the basis of the hedge makes the implicit assumption that market liquidity will not be a problem in the realization of a geopolitical event. The importance of liquidity was tested during the collapse of Lehman Brothers in September 2008. Gold prices declined sharply as both traded volumes and open interest on the exchange plunged. After this liquidity event, investors became more conscious of the physical vs. futures market distinction and began to demand more physical gold or physically-backed ETFs as a hedge against black-swan events.
Currie's conclusion: if buying gold, don't buy futures or ETFs - buy the real thing: "The lesson learned was that if gold liquidity dries up along with the broader market’s, so does your hedge—unless it is physical gold in a vault, the true “hedge of last resort."
The distinction of "electronic" or paper gold versus physical may be one the cryptocurrency community will soon be forced to learn, especially if North Korea does carry out, as it threatened over the weekend, an attack using an Electro Magnetic Pulse which could promptly empty all those bitcoin "vaults."