Currency traders rush to price in UK election uncertainty

Uncertainty over the outcome of the most closely fought general election in a generation has prompted signs of concern in financial markets, with investors buying up insurance against sharp swings in the value of the pound.

With less than a month to go and little separating the two main parties in the polls, the currency market has registered a pronounced rise in volatility, suggesting investors are preparing for a period of elevated political uncertainty.

Market measures of volatility of the pound against both the euro and the dollar have reached a level not seen since the formation and first year of the current coalition government.

The currency market has often set the tone ahead of bonds and shares, as a prompt for broader market unease — notably last year ahead of Scotland voting on the issue of independence. For now, UK government bonds and share prices have not been affected by the election campaign, but that may well change as the clock ticks down to polls closing on May 7.

“The UK political story has not really been priced in until now,” said Koon Chow, macro economics and foreign exchange strategist at Union Bancaire Privée.

The last time there was such a spike in the cost of insuring against currency volatility was in the immediate run-up to the Scottish referendum, he added. “Since then, markets have been too sanguine about the political risks faced by the pound, and today we have learnt that they are rushing to catch up.”

Opinion polls put the Conservatives, the dominant party in the coalition, and the opposition Labour party neck-and-neck, with no sign yet of Prime Minister David Cameron making the late breakthrough anticipated by Tory strategists.

The latest Populus/Hanover election outcome predictor for the FT - using the latest polling data - shows Labour edging slightly ahead with 278 seats (up three) and the Conservatives on 270 (down four) in the House of Commons. Such a result would give neither party a majority, leaving them reliant on the support of smaller parties.

Rick Nye, Populus managing director, said: “Labour are now the largest party in 58 per cent of the simulations run and Ed Miliband (the Labour leader) becomes prime minister on more than four occasions in every five.”

Markets are now weighing the possibility of Mr Miliband entering Number 10 in some kind of informal deal with the Scottish National party, which has offered to support Labour on the condition that it abandons further austerity measures to balance Britain’s deficit, currently running at 5 per cent of GDP.

While markets might be concerned about Britain’s public finances under Labour, a Conservative victory would raise another set of questions arising from Mr Cameron’s pledge of a referendum by 2017 on whether Britain should leave the European Union.

The rise of both the UK Independence party, which advocates British withdrawal from the EU, and the separatist Scottish Nationalists has left markets wary over the implications of the poll for sterling in particular.

Investors have pushed the cost of insuring against currency volatility over the next month for the sterling-euro pair to its highest level since 2010.

A similar index measuring the sterling-dollar pair soared more than 21 per cent on Thursday, leaving this relationship at its most elevated levels since September 2011.

For now, longer-dated insurance via currency options that run for a year, have not experienced a surge, suggesting fears over the UK leaving the EU or Scotland holding another referendum on independence are not worrying investors.

Jacob Nell, economist at Morgan Stanley, drew attention to the potential implications for the outlook for “fiscal policy, EU membership and the role of markets”, and the potential knock-on effects for the UK economy.

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The 4 key election battles

Projected election result for the UK as a whole and for individual constituencies.

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“While we expect the recovery will continue — even in the bear case of a minority government dependent on a challenger party for support — we think this combination of factors will have a negative impact on growth, in particular via lower investment, and on the pound, given the UK’s dependence on foreign inflows.”

Nour Al-Hammoury, chief market strategist at ADS Securities, said: “Pricing a sterling option contract with a strike price at $1.45 is very expensive, showing traders betting on further declines for the pound rather than a recovery.

“We see sterling remaining below $1.50 eyeing $1.45 and even lower. This outlook will not change until we have come through the election period, or until the US gives a definitive view on their long discussed rate hike.”

Against the dollar, the pound was down 0.4 per cent on Thursday at $1.4802, and has tumbled from $1.56 since the start of the year. The sliding pound has benefited hedge funds which placed bets via options earlier this year looking for a move towards $1.35 due to a combination of dollar strength and UK election uncertainty registering, said a trader.

Sterling has fared much better against the euro as the European Central Bank has launched large-scale purchases of bonds, designed to boost the economy and spur inflation, resulting in a weaker currency. The euro rose 0.1 per cent against sterling to £0.7256, but has fallen from £0.78 this year.