Sterling skidded over 1 percent against the euro on Thursday, hitting a three-week low as the single currency rallied on the back of the biggest two-day jump in German Bund yields since 2011. One week before British parliamentary elections that polls indicate will give no party an overall majority, investors appeared to be more focused on yield differentials and monetary policy than on political risk.
With German Bund yields jumping as data showed the euro zone ended four months of deflation in April, the euro traded as high as 72.97 pence. That left it on track for its first month of gains against the pound since November. "What you're seeing right now is a market that is hyper-sensitive to yield spreads," said Simon Derrick, head of currency research at Bank of New York Mellon in London.
"That's logical because yield spreads have become so miniscule that absolutely anything is creating, relatively speaking, a big shift." Against the dollar, sterling retreated from a two-month high, with the greenback boosted by US data that showed signs of a stabilising labour market and an economy gathering momentum, putting the Federal Reserve on track to raise interest rates at least once this year. Sterling traded at $1.5339, down 0.6 percent on the day but still on track to finish the month with a 3.5 percent rise against the dollar - the pound's best performance since September 2013, leaving it over 5 percent above the five-year low of $1.4567 it hit in March.
Analysts have played up the chance of volatile moves in the pound because of political risk. Prices of options guarding against such uncertainty have remained high. One-month implied volatility was trading much higher than two-month volatility, indicating weeks of uncertainty after the election. Sterling's rally followed minutes from the Bank of England last week showing it thought the interest rate tightening priced in by markets was "exceptionally slow". Many now argue that proves sterling is much more sensitive to policy expectation than to political risk.
"Sterling was tumbling into the election, so everyone assumed it was election uncertainty that was driving it. But I think what's become apparent in the last few weeks is that it's not necessarily the election uncertainty that's driven it at all," said Craig Erlam, a market strategist at FX broker OANDA.
"Now it's become clear that it is entirely central bank-driven, like every other currency, and the election is having no impact whatsoever." Ten-year British government bond prices fell modestly, easily outperforming plummeting German debt prices. At 1621 GMT, the 10-year gilt yield was up a basis point at 1.845 percent, having earlier peaked at 1.884 percent - its highest level in more than seven weeks.
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