The Fading Impact of Geopolitical Risks on Gold Prices

Friday, 08 Aug 2014 08:16 AM

By Ed Moy

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There is a growing disconnect between the traditional correlation between increasing geopolitical risk and rising gold prices.

Gold prices have generally correlated with geopolitical risk. When something bad happens in the world that could have negative impact on the global economy, investors abandon investments that might be impacted. Instead, they favor safe-haven investments like gold. Gold is a tangible asset that has a 5,000-year history of having intrinsic value, especially in times of trouble.

Remember in 1979 when 52 American diplomats were held hostage in Tehran and the Soviets invaded Afghanistan a month later? Gold skyrocketed from $380 to $850 an ounce. And when it appeared that Greece's financial problems might have brought down the European Union in 2011, gold jumped from $1,495 to $1,895 an ounce.

Today, the number of geopolitical risks outnumbers the past and has greater potential global economic impact.

Similar to the Soviet Union's invasion of Afghanistan to support a pro-Soviet government being undermined by the West, pro-Russian separatists launched a military campaign in Eastern Ukraine and Crimea, where 1,200 have died and 3,500 have been wounded in the fighting. And a civilian airliner was shot down killing all 298 aboard. With the threat of escalating sanctions and retaliation impact on the European Union's fragile economy, this crisis alone should have boosted gold prices significantly.

But Ukraine is not the only geopolitical crisis right now.

The Islamic State is al-Qaeda on steroids. Their recent military campaign has won large swaths of land in both Iraq and Syria, leaving 5,500 dead civilians and 11,665 wounded. They have robbed Iraq's central bank of $450 million, which makes them the best-funded terrorist organization in the world. Their goal is to make the world into a single radical Islamic state, and their tools include cutting oil supplies and terrorism.

By the way, the Islamic State is so bad that Syria has gone to war against them. Syria is no slouch in the violence department, killing 170,000 of their citizens during the last decade of civil war. Just two weeks ago, the Syria and Islamic State conflict racked up 700 casualties in weekend fighting, and 22 U.S. embassies were shut down this week because of al-Qaeda threats.

The Libyan civil war, which gave terrorists cover to kill our ambassador there, has claimed 4,700 deaths (plus 2,100 missing) since its start three years ago, and 97 people died and 400 were wounded in last weekend's fighting. Libya provides a significant amount of oil to the U.S. economy.

And last but not least is the Israel and Gaza conflict, which has left 1,800 dead and 10,000 wounded in the last two weeks.

Pushed to the back burner are the continued devolution of Afghanistan and Iraq after the premature pullout of our troops, Boko Haram causing mayhem in Africa by racking up 2,053 deaths and kidnappings of young girls and incurable Ebola spreading quickly in West Africa already killing almost 1,000 people.

China is also flexing its acquisitive muscles in the South China Sea by threatening Vietnam and Japan. Japan is re-arming for the first time since World War II because it is threatened by China and does not think the United States has their back anymore.

And on the economic front, Argentina is now in default for the second time, sending shock waves in the global economy. Italy just tipped into recession, while Portugal needed to bail out one of its banks to the tune of multibillion-euros.

Each of these geopolitical risks alone would have had a big impact on gold prices, but taken all together, gold should have sky rocketed. Instead, gold has traded in a tight range between $1,260 and $1,320 during this whole time. In fact, when some of these crises broke, gold went down as often as it went up. What gives?

There are three logical explanations.

First, this is an unusually high number of crises but it is a temporary state of affairs. It will eventually settle down to pre-2008 norms. Investors' strategy is to survive this bad period, assuming that no country wants to inflict worldwide harm, and therefore everything will get better soon.

Second, greater geopolitical risk is the new normal. What would have struck fear in the hearts of investors 30 years ago is now so commonplace that crises with global impact are shrugged off by investors hardened by the never-ending parade of worsening situations.

Third, the accommodative monetary policies unleashed by central banks around the world have flooded the market with cheap currency, which sustains record stock market highs and caps gold prices. If investors know that central banks will do anything to prop up their economies, they will take a lot of risk knowing that a bailout will protect them from downside risk.

Regardless of what explanation you believe in, gold prices are not rising as geopolitical risks increase in frequency and in magnitude. Investors are making as much money as they can until they can't. And when they can't, there sure is going to be a lot of interest in gold.

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