Sterling dipped back below $1.54 on Friday, more than a cent below 8-week highs hit a day earlier, with a growing focus on political risks ahead of May elections helping cool the past month's stronger mood towards Britain. The pound was also 0.3 percent weaker against the euro after breaking below 73 pence per euro to a more than seven-year high on Thursday, as interest rate expectations moved further in favour of British assets just days before the European Central Bank embarks on a huge asset-buying spree.
This week has seen a raft of warnings from analyst teams at major banks on risks to the pound, with worries over heavier spending and taxes and regulation on the financial sector by a centre-left Labour government top of the list. Options market pricing shows a jump in the cost of derivatives allowing investors to hedge against volatility around the most widely contested parliamentary elections of the modern era. Three-month implied volatility traded at 9 percent compared to around 7.35 percent for the equivalent 2-month option.
"Although FX markets currently appear indifferent, we expect politics to matter a lot for sterling as the election gets closer," analysts from RBC Capital Markets said in a report analysing the possible fallout of the May poll. "Based on current policy priorities, trading around previous elections, and our assessment of current market pricing, the only clearly GBP-positive scenario would be a limited swing in voting intentions toward the Conservatives."
That could also turn bad on UK markets. Even if he avoids being forced into a coalition with anti-EU party UKIP, Prime Minister David Cameron is committed to a referendum on EU membership that many is his own party believes should take Britain out. "It feels like the electoral risks are finally coming into focus," said Michael Sneyd, a strategist with BNP Paribas in London.
"After the strong performance since the start of this year, people are thinking that these are good levels to start to position for some nerves around the election. We are certainly in that camp." By 0913 GMT, the pound was trading at $1.5404 and 72.87 pence per euro respectively.
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