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).

The Washington risk premium is highly correlated to Trump’s approval rating 

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.

The Trump risk premium as reflected in real rates and the US dollar (as reflected in a basket of EM FX) explain 85% of the price movement 

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.