Going forward, there are possibilities of big moves to the upside and downside that could reawaken the sleepy options market and lead gold options to significantly higher levels of implied volatility. Although many factors influence gold prices, we see two elements playing a dominant role:

These two factors exert their influence in very different ways. The first is demand-based and moves gold prices on a day-to-day basis. The second is a supply-based influence that appears to move gold prices on a year-to-year basis. Both factors have the potential to create strong trends in gold prices and impact the implied volatility of gold options.

That U.S. monetary policy would impact gold prices is in some ways counterintuitive. The United States is a relatively inconsequential consumer of gold jewelry. Americans only consumed about 3% of the gold jewelry sold worldwide in 2016. This pales in comparison to the quantities sold in China and India, which totaled 33% and 25% of 2016 global sales, respectively. Europeans, too, love gold jewelry more than Americans, accounting for about 15% of global sales in 2016.

The reason why gold prices are so strongly influenced by U.S. monetary policy is relatively simple: gold is priced in U.S. dollars. Any action that the Federal Reserve (Fed) takes to weaken the U.S. dollar by lowering interest rates or expanding quantitative easing tends to weaken the fiat currency of the United States to the benefit of holders of gold. By contrast, any action the Fed takes to make the ownership of U.S. dollars more attractive, such as curtailing quantitative easing or raising interest rates, tends to send gold prices lower.

This is seen in the strong, negative correlation between day-to-day changes in the spot price of gold and day-to-day changes in the interest rate on Fed Funds Futures (100 minus Fed Funds Futures contract price). If expectations for the Fed to tighten policy increase, gold prices tend to move lower and vice versa. Moreover, gold is much more negatively sensitive to changes in U.S. interest rate expectations than are other precious metals such as silver, platinum and palladium (Figure 2).

Following the U.S. elections, expectations for higher interest rates soared, to the detriment of gold. Since late December 2016, however, expectations for Fed rate hikes have moderated as the Trump agenda hit a series of snags (Figure 3). Essentially, Trump has not been able to get any of his domestic agenda through Congress thus far. Healthcare reform flopped. Tax reform is still on the table. While the Administration has said it will release a tax plan soon, it’s not clear if it will make it through Congress. The Administration continues to advocate increased infrastructure spending but no detailed plan has been put forth and it’s not clear how Congress might react when such a plan materializes.

As such, gold is the ultimate hedge for setbacks in the Trump agenda. If the administration fails to get its plans enacted, gold prices will likely move higher. If the Administration succeeds, gold prices could retest or break their December lows. Although Trump’s presidency appears to be off to a rocky start, don’t count him out: many past Administrations took months or years to accomplish their main objectives.