DJ Forex Focus: The Pound Could Be Starting Something

This could be the start of a nasty pre-election tumble for sterling.

Over the last few weeks, the pound has been largely immune to political risk, finding support from strong economic data and a widening in sterling yield differentials against the dollar, the euro and the yen.

However, as the May 6 general election draws closer and fears of a hung parliament show little sign of receding, the pound is having a rougher ride, made only more difficult by a slump in global market sentiment as concern about Greek contagion refuses to go away.

See the pound's recent performance against the dollar:

A sign that the pound has only been held up this month by short-term speculative trades, rather than any longer-term investor flows, emerged Tuesday when the U.K. currency suffered a sharp downward jolt.

Although economic data have been relatively strong in the last few weeks, with inflation bouncing back even higher than expected, more recent figures may have taken the shine off recovery expectations. First-quarter gross domestic product growth was half the level that was expected and, despite a strong retail spending survey from the Confederation of British Industry, a low level of mortgage approvals suggests that house prices this year will remain flat at best.

Thus, Bank of England claims that inflation will fall back again and economist forecasts that interest rates in the U.K. will remain low for most of this year, if not all of it, could mean that yield spreads will fall back again.

This could certainly be the case if the U.S. Federal Reserve in any way hints at higher U.S. rates after it completes its policy meeting later Wednesday.

As the countdown to the election continues, the likely structure of a hung parliament and the risks it could pose to fiscal policy tightening is being hotly debated.

The problem is, no one really knows.

"It is not a foregone conclusion that a hung parliament has to be negative for the pound. We just don't know," said Simon Derrick, a senior currency strategist with Bank of New York Mellon, noting the possibly large size of Liberal Democrat participation this time puts any coalition in a new class of its own.

So with opinion polls still showing that the Conservatives don't have a clear and workable majority, more speculation over the future of the U.K.'s fiscal policy could take its toll.

Domestic developments aside, the pound is also facing pressure from the prolonged negotiations now taking place over how and when Greece will get funds from the European Union and the International Monetary Fund to help it cover debt payments starting May 19.

Despite reassurances from Angela Merkel that Germany will support the rescue package and the euro, the German Chancellor is facing stiff opposition within her own coalition.

As the perceived risk of contagion to other euro-zone debtors grows and fears of a more general sovereign debt crisis increases, investors are pulling back from risky markets at the expense of currencies such as the pound.

Derrick noted that this trend has only been made worse by recent warnings from China that it is also unhappy now that sovereign risk has become a "major and real threat to global financial stability."

For the pound, a failure to break over $1.55 leaves the currency exposed to fresh technical pressure on the downside, especially now that it has fallen through support at $1.5380. Further losses below $1.5300 are likely to set the pound on track for a revisit to this month's low at $1.5194.

Early Wednesday, the pound was a little lower like most other risky assets after Standard & Poor's downgrade of Greek long-term bonds to junk status and its lowering of Portugal's credit rating to A minus pushed general market sentiment sharply lower.

Stronger-than-expected inflation data for Australia as well as good retail sales from Japan have lifted sentiment slightly, but Asian stocks still declined with the Nikkei losing 2.6%.

The euro, which hit a one-year low of $1.3144, had rebounded to $1.3196 by 0645 GMT, compared with $1.3181 late Tuesday in New York, according to EBS.

The pound was down at $1.5252 from $1.5255, while the dollar was up at Y93.34 from Y93.18. The euro was also up at Y123.24 from Y122.85.

Bloomberg TNI FRX POV

   Reuters   USD/DJ    Thomson   P/1066 or P/1074 

(Nick Hastings has covered the foreign exchange markets and industry for over 20 years. Apart from his written commentary and analysis, he also appears on Fox Business News and CNBC television in Europe, Asia and the U.S. He can be contacted on +44-20-7842-9493 or by email: nick.hastings@dowjones.com)