Political Fears Will Continue To Haunt Sterling. By Nicholas Hastings

The pound's decline may take place in slow motion but it will still come.

Debt developments in the euro zone and continued hopes for a global recovery may well distract market attention from sterling's problems.

But, as Monday's sudden downward jolt shows, fears of a hung parliament and a double dip recession will continue to haunt the currency, with analysts now expecting it to fall as far as $1.20, or down to parity against the euro.

The pound has already fallen under $1.50:

Click Image to Enlarge


So just how important is a hung parliament in terms of scuppering sterling's future?

As we get closer to the general election that must be held by early June, the chances of a clear Conservative victory appear to be sliding. Recent polls suggest that the party's lead has now shrunk to anywhere between 2% and 7%, with a strong chance that neither Conservative nor Labour will be able to command a majority in the House of Commons.

In essence, this shouldn't matter. Some analysts argue that cross-party consensus to reduce the country's whopping budget deficit should ensure that appropriate legislation will be taken whichever party is in power.

Pressure for swift action will certainly intensify if the credit agencies continue to circle, threatening to downgrade the country's debt rating if the deficit isn't reduced fast.

Investor pressure could also become more acute at that stage, especially if the debt crisis in Greece and other indebted euro-zone countries has been resolved, allowing their focus to shift to the next great debtor--the U.K.

However, faith in a hung parliament flies in the face of tradition. Repeated attempts to form U.K. coalition administrations in the 1970s essentially failed. In that case, ending with a sterling devaluation and a visit by the International Monetary Fund.

And the last time the country was ruled by essentially a tiny minority under Prime Minister John Major in the 1990s, sterling ended up being ejected from the exchange rate mechanism.

So as opinion polls gyrate ahead of the election, which the ruling Labour Party has yet to call, sterling will remain very vulnerable as international investors fear that they will end up with a devalued currency on their hands.

If politics weren't bad enough, economics are proving to be no help either.

News that fourth-quarter GDP growth had been revised up to 0.3% from 0.1% lifted recovery hopes only briefly. A breakdown of the GDP data shows that the majority of the expansion came from government-funded spending rather than increased consumer activity. That is hardly a sustainable growth trend that would allow the country to start paring back its deficit.

As a result, the prospect of a 'double dip' recession has increased sharply and market participants will now be looking with interest to see if the Bank of England moves any closer to restoring quantitative easing when it completes its next policy meeting Thursday.

Against a backdrop of a global economic recovery and hopes for an early normalization of monetary policy in most major economies, such as move by the Bank of England would only spell further losses for the pound as the U.K. falls to the bottom of the recovery league.

Early Wednesday in Europe, the pound was starting a little higher, helped by a general improvement in market sentiment on hopes that Greece will outline a convincing austerity package later in the day and pave the way for a successful bond offering before the end of the week.

Market participants also expect support from the latest purchasing managers' index for the service sector in the U.K., which is forecast to have risen to 55.5 in February from 54.5 in March.

News that a sharp fall in Prudential's share price might prevent it from closing a takeover deal of an AIG unit in Asia also provided the pound a little lift. The deal, worth $35 billion, had initially hurt sterling.

By 0745 GMT, the pound has risen to $1.4998 from $1.4960 late Tuesday in New York, according to EBS.

The dollar rose a little to Y88.85 from Y88.75 while the euro rallied to $1.3621 from $1.3607. The single currency also rose to Y121.06 from Y120.75.