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Election outcomes for gold price: from a slow grind higher to an explosive rally

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(Kitco News) With the U.S. election just one week away, volatility is rocking the financial markets, except for the gold sector, in which investors remain very cautious ahead of the big event.

There are four main scenarios investors are preparing for come election day — a Democratic sweep, a Trump win, a split Congress, or a contested election.

All of the above are likely to trigger higher gold prices in the long-term, but one might set off an "explosive" rally while others are likely to lead to a "slow grind higher," according to Pepperstone head of research Chris Weston.

"Longer-term, all roads lead to higher gold prices," Weston told Kitco News on Friday.

Blue wave

The most explosive scenario for gold would be a blue wave at the polls with the Democratic candidate Joe Biden winning the presidency and the Democrats getting control of the Senate.

"What is the scenario which drives up inflation expectations, brings the Fed in to keep long-term borrowing costs low and makes real rates go down to 2%. If you can work out which is the quickest scenario to get there, that will be the most bullish one for gold. And that, to me, looks like a blue wave," Weston said.

In a simplistic overview, a blue wave scenario, which is not yet fully priced in, is likely to trigger a lower U.S. dollar and higher gold prices, Weston explained.

"The conventional wisdom is that if we see this blue wave scenario, then the dollar will get smoked because the chances of passing massive stimulus become much greater," he said.

However, markets could also see the U.S. dollar rise in case of a blue wave scenario because, with the new stimulus, the U.S. is likely to remain an attractive investment destination in relative terms, Weston added.

"Wouldn't be surprised to see the dollar strengthen in light of the relative attractiveness of investment destinations around the world. Europe has this big COVID issue that is becoming more prevalent. We are seeing signs of concern like a deflation problem," he said. "But if you look at the U.S. — $3.5-trillion stimulus plus a more aggressive Fed … We start talking about that U.S. exceptionalism story, which creates a flood of inflows into the U.S. And suddenly the dollar strengthens. One of the reasons why the U.S. dollar does so well is because the rest of the world looks less good."

Yet, whether the U.S. dollar rises or not, the important thing for the gold traders is that the precious metal will climb higher either way.

"You could see a situation where the U.S. dollar strengthens and gold rallies alongside it because of the closer move to MMT and deficit spending. Gold does very nicely in that environment," Weston noted.

Trump win

In case of a Trump win, Weston prices in a smaller gold price rally, stating that a lot will depend on the Senate outcome as well as the economic recovery.

"The status quo is good for gold. It really depends on what the economy is doing at that time and what it needs. If Trump is at the White House and we've got the GOP running the Senate and Democrats are running the House, it really depends on what the economy looks like. There will be a need for more stimulus. But is that going to be half a trillion, a trillion, or something much more punchy?"

If the amount of stimulus the economy gets is on the low side, "gold will probably rally, but it will be more of a grind than an explosive move," Weston pointed out.

In case of a low stimulus, there will be more emphasis on the Federal Reserve to step in to do more, according to Weston.

"We know what the Fed is trying to do, but we don't know how it is going to do it," he noted. "We suspect the Fed will give us more of a clue about how it will generate inflation expectations at the December meeting, and that will be good for the gold market. It is really all about real inflation-adjusted Treasuries."

Split Congress

A split Congress is the scenario markets seem to be pricing in the most at the moment, said Weston.

"If you look at the gold market now, it is pretty much unconvinced by this blue wave idea. They are looking more at a split Congress scenario. If you look at the volatility options market, call volatility is only trading at a modest premium to put volatility. So the idea that if we are going to see a move that will be slightly more explosive to the upside than downside over the one-month period, that has come down very sharply. If we were really bullish on gold, it would be higher. It's very neutral now," Weston explained. "The sentiment in calls versus puts, it is very neutral. The options market is not telling me that they are expecting this dynamite move to the upside."

This kind of positioning is more reflective of a split Congress scenario, which is all about waiting for signs of fiscal stimulus in 2021 and signs that the Fed will actually do what it is supposed to.

"We've got a lot of clarity around what the Fed's mandate is. We just don't know what they are going to do. Once we firmly understand, the gold market will respond," Weston said.

Split Congress scenario means that the fiscal impulse becomes less prevalent, which puts more emphasis on the Fed trying to generate inflation through their mechanisms. "A split Congress brings the Fed more in. And I think the gold market is going to be looking at what the Fed can do to lower rates, which is why you have this kind of a holding pattern," Weston noted.

Contested election

A contested election is a more likely outcome if the election is a close one. Civil unrests are also quite likely in this outcome. However, the impact on the markets will only be felt if these delays and possible unrests impact the economy at the national level, Weston pointed out.

"If Trump sees some irregularities, it does feel like there is an elevated risk that he'll take it to the Supreme Court. If Trump doesn't accept the results, the prospect of civil unrest is obviously high. It doesn't take much at the moment to cause unrest," he said. "But markets would only get concerned if a contested election means that it would actually hit economics on a national basis."

If that is indeed the case, then markets should expect to see a move down in Treasury yields, and gold is likely to benefit from that.

"Depends on what contested election actually means and how long it will go on for. The reaction in markets comes from how it all impacts the economy. Gold will work as a hedge against that," Weston added.

Come next week, trading the actual election day will be difficult since the results might not be known as quickly as before.

"It is about how long until we see the overall results, including the Senate races. Markets want to know instantly. The quicker we can get an outcome, the quicker the business community can go about their daily lives understanding the investment landscape they have to work in — the fiscal situation, regulations, and taxation," Weston stated. "Because fiscal is such a dominant story right now, the ability to pass a big fiscal stimulus or ability to pass anything given what we've seen recently is the dominant story."

The more uncertainty drags on, the more fearful the markets are likely to get.

"Gold's price action will depend on volatility in this scenario. If there is a big drop in markets, we know that gold doesn't necessarily work as a safe haven because some people sell gold to pay for other assets. The positioning in gold is much more neutral than it has been for some time. Some people have been using gold as a hedge against the negative outcome," Weston said.

Overall, Weston does not see a case where the gold price gets crashed since the long-term investment case stacks up for the precious metal.

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