Are we headed to reflation or stagflation? Instead of asking this overplayed question, investors should perhaps be asking if an impeachment of Donald Trump is possible. Gold, in fact, thinks so, and has received some decent bids on this remote possibility. The puzzling bidding of gold (NYSEARCA:GLD) contrary to interest rate fundamentals in the last few weeks, especially after the inauguration of Donald Trump as the new US president, raised questions. Real interest rates in developed economies picked up slightly which should normally pressurize gold. Instead, gold turned its back on its bearish macro backdrop, and began responding to a new possibility; the remote, nevertheless non-zero, probability of an impeachment of the new US president. Gold's positive reaction to this new potentially destabilizing factor looks quite sensible if we consider that investors typically overreact each time a new remote possibility emerges in global markets. This is what cognitive psychologists call the "possibility effect" and it is what probably fueled the rebound of gold. If this faint "smell" of impeachment intensifies further down the line, gold can keep defying its bearish macro fundamentals for longer.
"Smell" of Impeachment In The Air?
While any such talks about impeachment so far have been more wishful thinking than a real threat, people have started to factor in such a destabilizing possibility, primarily due to the many unsubstantiated claims from ties to Russia to conflicts of interest within his administration. Google searches about the term "impeachment" in the US have spiked after Trump's inauguration but worldwide Google searches for the term "Trump impeachment" have skyrocketed.
The new US president is certainly not invulnerable. In fact, his constant attacks against the press, his erratic decision-making processes, his ethics violations (some of which he has already been counseled for), not to mention his tweets, are what makes the gold market react positively to this faint possibility. When investors focus on an unlikely event for the first time, they attach to it a much bigger weight than it deserves. This is called "the possibility effect", a well-documented phenomenon in people's choices under uncertainty. To illustrate this fact just consider that for very remote events with probabilities of 2% to 5% people assign to them as much as three times higher decision weights. A 5% probability of an event is treated as a 15% one. Under such light, gold erases some of the losses it incurred after the US elections in response to the remote possibility of Trump's impeachment.
Divergence From Real Rates
It should come as no surprise, though, that gold recently became detached from its fundamentals, i.e. the long-term real interest rates. Until early January, gold had been moving in reverse order to the long-term real interest rates. As a matter of fact, as the 10-year US and UK real yields spiked upwards after the US election, gold plummeted. Then, when the Trumpflation trade faded out between mid-December and early January, real rates came back down and gold rebounded accordingly. This follows a well-established phenomenon, which stipulates that as real rates go up the investment demand for gold drops, since the increasing real return on cash makes investors unload gold for cash. However, this negative correlation broke down completely since Donald Trump's inauguration (to the right of the red dotted line A). The combined 10-year real rates of the US and the UK moved slightly upwards while gold received some decent bids pushing it towards the $1.240 area.
Source: tradingview.com, Fed of St. Louis, US Teasury Department, BOE.
More interestingly, though, gold did not appreciate only vis a vis the US dollar (NYSEARCA:UUP), but gained ground against the emerging market (EM) currencies (NYSEARCA:CEW) too. The price of gold versus a basket of EM currencies broke its major downward trend line (trend line B) to the upside, reversing its previous bearish dynamics. This coincided with the breaking down of the correlation between gold and real rates. A common force seems to be the driver of gold's rebound against all currencies, and the possibility of an impeachment further down the line could play that role. In fact, a Trump impeachment could make sense for the break to the upside of the price of gold against EM currencies as well. One of the cornerstones of Trump's mantra is the deregulation of US banks. Should a full blown deregulation materialize, EM economies will receive a major boost from the alleviation of the looming US funding shortage. After all, the expectations of such a deregulation were the reason that EM equities (NYSEARCA:EEM), bonds (NYSEARCA:EMB), and even currencies held pretty well this year. Conversely, any hint that the implementation of the regulatory pillar of Trump's economic policy might be derailed could reverse the EM optimism. In fact, such a process could already be underway, making gold gain ground against the currencies of these economies.
Gold rarely diverts from its interest rate fundamentals. Currently, investors are witnessing such a rare occasion and are looking for an answer. As long as the gold market focuses on the remote possibility of an impeachment strong bids can be expected; and for anyone that might dismiss this event as mere fiction, the very election of Donald Trump proved that we are living in a time when the impossible is, in fact, possible.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The views expressed in this article are solely those of the author, provided for informative purposes only and in no case constitute investment advice.