Last night, we asked if gold might be overbought amid all the fretting over whether North Korea will or won’t pick a nuclear fight with Donald Trump (which is a lot like arming yourself with a butter knife and jabbing it into the ribs of a coked-out chimpanzee waving an M4A1 carbine).
This chart would seem to suggest the answer is “maybe”, although we’re not much on this kind of “analysis” (i.e. RSI):
The question on everyone’s mind here is whether the yen will cease to be a suitable haven in the event there’s an actual war in Asia. Presumably, gold and the franc would be the next best thing right up until everyone starts hoarding bullets, kerosene and Vienna sausages.
Of course as noted yesterday in the piece linked above, you have to weigh this against the outlook for real yields. “Gold is still just an inverse real yield play,” Mark Cudmore wrote last week, adding that “since most major central banks – such as the Fed and the ECB – are more likely to hike rather than cut rates as their next move, despite a lack of sustained inflation, it’s unlikely the next major move in real yields is going to be lower.”
Ok, so Goldman is out this morning taking up this debate and their view is essentially that thanks to Harvey reducing the chances of a government shutdown, and thanks to the fact that yields have already fallen as far as they have (i.e. “how much more dour can the outlook realistically get on the prospects for fiscal policy in the U.S., and besides, yields are likely to get some kind of boost from the Fed announcing balance sheet normalization), the bad news is probably priced in as far as rates and the dollar are concerned.
“In coming months, the unfortunate aftermath of hurricane Harvey suggests that Washington is going to have to overcome their differences, pass spending bills, try harder to avoid a government shutdown and pursue infrastructure projects sooner than later,” Goldman writes, before adding that in their view, “the probability of a government shutdown has declined further to around 15% [and] a result, we are maintaining our end-of-year gold price forecast of $1250/toz barring a substantial escalation in North Korea.”
That last bolded bit is obviously the question. For now, it’s largely the same old story: the market isn’t predicting nuclear war and as we’ve noted on too many occasions to count, anyone who is predicting that has probably skipped straight over gold to buying canned goods and bullets. Here’s Goldman again:
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.
Ok, whatever, right? There’s nothing “stable” about an “equilibrium” that includes Kim and Donald Trump.
So how has gold performed historically when it comes to hedging geopolitical risk? Well, Goldman is glad you asked. Here’s how:
Given the above, 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.
Probably the most important takeaway from Goldman’s piece has nothing to do with any of the above and everything to do with the notion that to the extent you are serious about holding gold as a hedge against black swans, you should probably “accept no paper substitutes.”
And on that note, we’ll leave you with the bank’s warning on that:
One lesson [investors have] learned is 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.”
