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.
“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.”
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.