LONDON (ResourceInvestor.com) -- As trade relations between the U.S. and China become thornier and the tone of public discourse in the U.S. turns more towards protectionism, a trade war is becoming a significant possibility. If this scenario does develop, then what is the outlook for gold?
An examination of this issue follows on from a detailed look by your correspondent at the increasingly protectionist climate of the U.S. political arena. Please click to refer to this article.
The answer to the title question of this article depends in large part on the timeframe considered. The short and long term forecasts for gold under the circumstances envisaged are quite different.
If one takes the stability of the U.S. dollar as overwhelmingly the key factor affecting the gold price in this day and age, then the effect of a trade war on the parity of the dollar must be the main consideration here.
The initial effect would be the precipitation of a dollar collapse, as one of the reactions of the Chinese to the implementation by the U.S. of protectionist measures aimed at Chinese exports will likely be to cease purchasing U.S. treasuries with the foreign currency reserves that China's central bank is constantly accruing at a high rate.
This, and the following suit by other East Asian central banks that it would trigger, removes the most important source of funding for the U.S. trade deficit and hence the primary support for the dollar at its present level. Thus, the dollar would immediately fall and gold would immediately appreciate.
China would also respond to sanctions against it by restricting its imports from the U.S., lessening the demand for dollars on the open market. This would further weaken the dollar and hence stimulate a further advance in the gold price.
However, by now a new factor will have kicked in. The withdrawal of Chinese support for the dollar would constitute the definitive reckoning for the currency, and would mark its return to stability, albeit at a significantly lower parity.
After an initial rise in the gold price in response to the dollar's weakening, then the metal should, assuming all other things to be equal, be set to depreciate in value over an indeterminate period.
The dollar would have stabilised and could once again be relied upon as a store of value and as the currency of a large and advanced economy, undermining the main factor that has caused the appreciation of gold in the recent years.
In addition, the stability of the dollar only remains such a key influence on gold as long as widely accepted alternative global reserve currency does not exist. Acceptance of the euro is building as a viable alternative, and there are also other candidates like the yen and the won. For more analysis of this trend please see .
The degree to which these alternatives are taken up will of course affect the gold price. The faster they gain acceptance then the less extreme and less enduring are the effects of the dollar's moves on the price of gold.
If a transition to the use of new reserve currencies were rapid and complete enough, then gold could be cut out of the equation entirely and be left to depreciate to well below its current level. This though is unlikely; the transition would probably not reach completion quickly enough, and a role for gold would remain.
It should be stressed that the postulation of a simple linear relationship between the real purchasing power of gold and that of the dollar is invalid as far as this question goes and indeed as far as any analysis of the gold price goes. The crucial factor is the instability of the dollar in the absence of suitable alternatives, allowing gold to step in to the void as a quasi currency.
Looking further ahead, then depending on how long the U.S. allows the trade war, if it materialises, to persist and on how well the Europe and East Asia can pick up the slack left by the slump in U.S. demand for imports, the world economy might be tipped into a downturn. A nasty period of economic weakness in the U.S. in response to a further decline in the dollar remains a possibility, and some spill over to the rest of the world is likely.
A period of deflation could even be the result of a lengthy and severe trade war, and this might have a depreciative effect on gold as major currencies become more valuable in real terms. An alternative effect though is that gold would become more valuable as times became more uncertain in economic respects. At this stage in history though, the latter effect is much less likely than it once was.
But overriding either effect in importance would be the diminished demand for gold in industry and for making jewellery in the event of the global economic damage, whether or not an outright downturn is created, that a trade war between the U.S. and China would do. This would hence be negative for the gold price.
In the end though, much of this discussion is probably destined to remain untested by the unfolding of reality. Once the dollar collapsed following the initiation of a trade war with China the realisation would probably soon dawn on U.S. policymakers that their best course of action would be to return to free trade relations.
After this, gold would be set for a gradual decline, owing to the stabilisation of the dollar and the coming to the fore of alternative reserve currencies.