25 MAR, 2022
By Stefan Hofrichter
The invasion of Ukraine, long prepared by Russia and feared by the democratic world, began on 24 February. For the people of Ukraine, this is a humanitarian catastrophe; for the world, the breach of international law represents a real threat to the existing security order.
But what does this crisis mean for currencies, especially for the (trade-weighted) US dollar as the world’s reserve currency? And what for gold, which for many has the status of the safest currency haven of all? Both the US dollar and gold have increased in value since the invasion of the Russian army. But is this price movement really typical for times of increased geopolitical risks?
It is worth taking a closer look. To this end, we have analyzed a series of past events in more detail that showed parallels to the current situation. These were crises in which either at least one political superpower – the USA or Russia / the Soviet Union – was involved in armed conflicts or was on the verge of such and/or in which a significant oil price-related increase in inflation was observed or at least feared. Specifically, these were the tensions between the USA and North Korea (2017), Russia’s invasion of Ukraine (2014) and Georgia (2008), the Arab Spring (2011), the two Iraq wars (2003, 1991), Nato’s intervention against Serbia in the Kosovo war (1999), the introduction of martial law in Poland (1981) and the two oil crises (1973, 1979). The Soviet Union’s invasion of the GDR (1953), Hungary (1956) and Czechoslovakia (1968) as well as the Cuban Missile Crisis (1962) were not taken into account because these events occurred during the Bretton Woods system, in which the US dollar was pegged to the price of gold.
The result: in most cases, the US dollar did indeed strengthen in the quarters following the events mentioned, on average by a little more than 2 per cent. The periods of appreciation were often accompanied by a global economic slowdown and thus pointed to an impending US recession. Only after the start of the second Iraq war (2003) and the Arab Spring (2011) did the greenback depreciate quite significantly. In both phases, however, there was a global economic recovery, in which the greenback is typically under pressure.
Gold performance in the months following geopolitical crises, on the other hand, was very mixed: it was very positive after the two oil price shocks in the 1970s and after the outbreak of the first Iraq war and the Arab Spring, but negative in 1981/82, 1991, 2008 and 2014. In the end, the respective gold price development reflected the ups and downs of inflation and real interest rates rather than the crises.
A look at the past thus shows that the simple heuristic often quoted by market participants – US dollar and gold win in times of heightened geopolitical tensions – is not necessarily true. The effects of such events on the financial markets always have to be assessed within the general economic context. Incidentally, this also applies to the stock and bond markets.
Looking ahead and for the coming months and quarters, the following economic developments are thus likely to be decisive for the direction of the US dollar and the gold price: First, the rise in commodity prices. The sharp rise in prices for energy sources as well as industrial and agricultural commodities is likely to dampen global economic growth and at the same time ensure persistently high inflation rates. The spectre of stagflation is back. Second, monetary policy. Despite increasing risks to growth, Western central banks are likely to initiate or continue the announced normalization of monetary policy. This is especially true for the US Federal Reserve.
The reason for this is that inflation rates in the Western world have already been well above the central banks’ inflation targets for several months, with the result that companies and households have raised their inflation expectations. Monetary policymakers will try to anchor these expectations. Moreover, since the end of last year, the monetary watchdogs have increasingly pointed to underlying inflationary pressures and tight labour markets. The Fed in particular has recently made repeated statements underlining its determination to normalize monetary policy. It would therefore probably take a significant and uncontrolled movement in the financial markets to dissuade the central banks from this course.
Despite an already high valuation, the combination of weaker global growth and rising US interest rates therefore currently implies further appreciation potential for the US dollar. The outlook for gold, on the other hand, is less clear. The inflation dynamic argues for a further rise in the price of the precious metal. The expected interest rate hikes, in contrast, are a headwind – especially if they also lead to higher real interest rates. This would increase the opportunity costs of holding gold.