BNY Mellon: Geopolitics And Low Volatility

Feb 18, 2019

With geopolitical tensions growing around Venezuela, Kashmir and the South China Sea, the lack of market response. has been notable. It’s worth considering why this might be happening.

Gold’s role is as a hedge against currency debasement. It was put to good use in this respect from 2001 to 2012 during which time it rose by 550% as US inflation exceeded the Fed Funds target rate by an average 0.2% points.

It follows that gold normally performs poorly in the face of geopolitical tensions that pose risks to asset prices and/or economic growth. This was shown on a number of occasions over the past fifty years.

When the major currencies started to float against each other after the breakdown of the Smithsonian Agreement in 1973 the great 1970’s gold price rally was under way. However, prices began to fall back in the July of that year as investors feared for the huge economic drag of a geopolitically-inspired rise in oil prices. What was more telling was the performance of gold both during and after the October War (and the subsequent oil embargo), falling nearly 30%. In contrast the USD rose sharply during this period.

On November 5 1980, the election of Ronald Reagan marked the start of an 18 month downtrend in gold prices that saw the metal lose half its value against the USD. Although a good portion of this can be attributed to Mr Volker's anti-inflationary efforts at the Fed, this period also marked the real start of the Second Cold War.

This pattern can be seen a s recently as February 2013 when a significant price declines coincided with the news that North Korea had vowed more long range rocket tests Further falls came as North Korea threatened South Korea with "final destruction” while the heaviest losses came in April following a warning that Tokyo would be the first target in the event of a war on the Korean Peninsula.

It’s arguable, however, that this pattern has changed over the past five years. The first evidence of this emerged during the annexation of Crime in early 2014 when the market simply failed to respond in any major way to events (although regional markets did). A similar pattern was subsequently seen during the failed coup in Turkey.

The most likely answer is that since the taper tantrum of 2013 investors have become used to a rather more fine tuned response from the Fed to signs of market turbulence. This implicit promise of relatively easier US monetary conditions during times of heightened stress therefore works to offset the demand for the USD that might normally be expected during these times. The net result is that times of heightened geopolitical risk are met by currency markets (and gold prices) that become less rather than more volatile.

Curious.