Politics set to put GBP on a roller coaster
The UK is facing the most interesting election in a generation on May 7 with no single political party looking like it will be able to win enough seats to rule on its own. It's great drama for political wonks, but a big source of concern for GBP.
Looking at the recent performance of GBP anyone could be forgiven for wondering what the fuss is all about. After all GBP/USD has stabilised recently. Against other currencies GBP has done better. This is due to a combination of relatively robust UK economic numbers and weakness in other currencies.
Yet there are plenty of reasons to feel concerned about the outcome of the UK election. The financial markets would very much favour a victory by the Conservative party and this would be bullish for GBP (this could still be the outcome). They're the most committed to reducing the UK's budget deficit and have taken most of the credit for the UK's economic recovery.
The Conservative party may just be able to pull together enough seats to be the largest party in parliament, just ahead of Labour while its current coalition partners – the Liberal Democrats look set for a drubbing.
But such are the dynamics of this election that they may not get to form a government. A left wing alliance championed by the Scottish National Party (SNP) is building to keep the Conservatives out of government. A Labour-SNP alliance will be seen by the markets as a better outcome than a hung parliament therefore avoiding the need to hold the election again. The two parties would probably have enough seats to rule.
GBP/USD – brace for volatility
Potential for political clashes
At the last election a Conservative-Liberal Democrat coalition looked improbable enough, but it worked. Labour-SNP looks even stranger. Though both are left wing, the number one policy of the latter is for Scotland to leave the UK. The alliance could be a fraught one with the SNP not only pushing Labour to the left (this will worry financial markets), but will demand further autonomy and wealth transfers to Scotland in exchange for keeping Labour in government. This will be very divisive.
The SNP has a very narrow set of interests and doesn't care about the fate of the rest of the UK, while Labour has a national focus. Scotland accounts for only around 8% of the UK's population and GDP.
Therefore there is a real danger of public acrimony between the two parties and political instability. If the two parties can't work together another election will probably need to be held. Over in the options market traders are taking big bets on GBP falling after the election.
The other vulnerability for GBP is the UK's large current account deficit standing at 5.5% of GDP, which has narrowed from 6.1%. It's caught the attention of the Bank of England, which is concerned that in adverse circumstances it could trigger a deterioration in market sentiment towards the UK. A period of political instability could conceivably represent such circumstances.
All these factors weigh against GBP. However, the economy is likely to be able to ride through a period of political paralysis and a weaker GBP may help the economy further by boosting exports.
But in the meantime, some large swings in GBP are likely over the next few months with levels of 1.4500 and even 1.4000 at risk of being tested. On the other hand, there is the prospect of a break through above 1.5000 if there is a decisive result from the election.
By Justin Pugsley, Markets Analyst, MahiFX