Sterling faces Lehman moment as reality of lose-lose election sets in

By:
Solomon Teague
Published on:

The UK has entered election mode, with concerns about the country’s political future dominating trading in sterling. Volatility is rising and investors are seeking protection in the options market.

In a sense, the UK election is fortuitous timing for the ruling Tory-Lib Dem coalition ahead of the May 7 election.

After a slowdown in the final three months of 2014, economic activity is back on the rise. Q4 GDP numbers were recently revised upwards and Q1 GDP growth looks set to be slightly stronger.

Jane_Foley-160x186
 While sterling could be on the back foot versus the EUR in the coming
weeks, we continue to see scope for EUR/GBP to trend lower

Jane Foley

Consumer confidence is among the positive indicators, having hit a 12-year high in March. Unemployment is falling and optimism is rising, “signalling that perhaps the uncertainty of the [election] outcome won’t be as destabilizing as some fear”, says Andy Scott, associate director of FX advisory services at HiFX.

This has all created a favourable environment for sterling. In the past 12 months, sterling has been the third best-performing major currency – after the USD and CHF.

Jane Foley, senior currency strategist at Rabobank, says: “Sterling has found good support this year from relative interest-rate differentials as policy action from the European Central Bank and other European central banks has driven down rates on the other side of the Channel.

“Even though the Bank of England is in no rush to hike rates, MPC members have played down any risk of a rate cut, so we expect interest-rate spreads to continue to support sterling this year, albeit it at a moderated pace.”

She adds: “While sterling could be on the back foot versus the EUR in the coming weeks, we continue to see scope for EUR/GBP to trend lower towards the 0.70 area on a 12-month view.”

However, this is not the whole picture and in recent weeks the tide has turned. March saw sterling fall against major G10 currencies and analysts expect sterling to weaken further as the election draws closer.

Adam Cole, head of G10 FX strategy at RBC, notes its economic surprise index for the UK turned sharply negative in March, having been positive for 16 straight weeks – though it is tentatively rising again in April.

Given UK rate expectations have moved little in that period, it is likely that pre-election jitters are driving this reversal in sentiment, says Cole, adding: “It is far less clear how political risk will drive GBP in this election campaign than in previous, largely binary, elections where FX markets have shown a clear preference for Conservative-led governments.”

Greater risk

A country that has long enjoyed strong, single-party governments under its first-past-the-post system seems reconciled to a future of hung parliaments and Europe-style coalitions. Opinion polls suggest this outcome is likely, while the increasing popularity of fringe parties – particularly the UK Independence Party – presents a kaleidoscope of potential outcomes.

Some of these concerns are natural hazards currency markets habitually navigate in countries where coalition governments are the norm. There is a greater risk that the UK might see delays in the formation of its next government after the election result. Once a government has been created, there is greater concern than usual it might not survive a full term.

However, these concerns are being compounded by what many see as unappealing options available to the electorate.

Of the two main parties, the Labour party is seen by many in the City as anti-business, having spent much of the past five years threatening to raise the top rate of tax and more recently solidified this impression with its threat to abolish the rule allowing non-domiciled taxpayer status.

Meanwhile, the Tories have promised to hold a referendum on the UK’s EU membership, inviting considerable prolonged uncertainty to the business climate – with the potential loss of the single market.

For many businesses, it feels like being stuck between a rock and a hard place.

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To make matters worse, GBPUSD options activity indicates there will be a high number of expiries occurring on May 7, says Kathleen Brooks, research director at Gain Capital. More will follow the next day, when negotiations between parties that failed to win an outright majority would begin.

“[This] could add to the downward pressure on the pound from May 7, making any potential sell-off even worse,” says Brooks. “Thus, we would expect the market to spurn the pound in the days before the election, and going long the pound may only be for the very brave.

“[Meanwhile] volatility in GBPUSD options expiring in three months’ time is at a four-year high, and has been steadily rising as we move into UK election season. This compares with USDJPY, where volatility has moderated. The pound is one of the most volatile currencies in the G10 as we lead up to polling day.”

In the last election, GBPUSD volatility was at similar levels to now – 12% – says Brooks, though it jumped sharply when it became clear the result had been a hung parliament.

“Volatility peaked at nearly 17% in the two weeks after the election,” she says, both due to the uncertainty around the formation of the coalition and as the resulting emergency budget spelt out the full horror of the UK’s finances.

Brooks says: “We would expect GBPUSD volatility to surge in the days after a hung parliament. This could weigh on the pound, especially if none of the major parties is able to form a coalition, leading to a re-election down the line. This could be the UK’s Lehman’s moment, and GBPUSD could fall back towards the post-Lehman low of 1.35.”

While not everyone is necessarily expecting a Lehman-esque doomsday scenario, HiFX’s Scott says “traders are likely to be cautious in regards to being too exposed to sterling, given the potential for increased volatility in the lead up to and just after the election”.

Political uncertainty

Ultimately, this election is increasingly characterized by the fact that there isn’t any outcome that would please the sterling market.

RBC’s Cole says: “A Conservative-led coalition outcome would cause us to revise GBP significantly stronger, but an outright Conservative majority [and a certain EU referendum] would cause to revise it considerably lower.”

Before the 2010 general election, there was also a high level of political uncertainty, with a hung parliament seen as a strong possibility, despite their rarity, even before polling day.

“[Despite this] sterling did not seem to be particularly concerned by election jitters, finding itself as the third best-performer among the major currencies on a one-month view,” says Brooks.

And Rabobank’s Foley says, even during the week of coalition negotiations, sterling remained stable, making slight gains versus the EUR and the USD.

Then, however, the markets could at least hope the Tories could translate their lead in the polls into an outright election victory, and the vulnerability of the Labour party put the right in control.

The UK’s deficit is smaller than five years ago, while the backdrop in the eurozone – while not being benign – is at least calmer.

However, these factors do not appear to be offsetting the dearth of appealing choices for the sterling market.