Sterling Faces The Worst Of All Worlds. By Nicholas Hastings
Uncertainty over the U.K.'s political future, a bearish policy setting whoever is in Downing Street and global sentiment on a knife edge will all keep sterling on the slide.
Before last week's election, there was still some hope that an outright Conservative victory would bring a swift deficit reduction plan that would convince financial markets and prevent a downgrade of the country's credit rating.
The actual result, leaving the country with a coalition government that could easily fall apart and force another early election, is the worst of all worlds.
At the moment, Conservative leader David Cameron is still struggling to negotiate a deal with the Liberal Democrats, while Labour Prime Minister Gordon Brown remains in Number Ten hoping to step in and preserve his premiership if the Cameron talks fail.
Not only will either Cameron or Brown be required to fight the country's biggest fiscal battle with one hand tied behind their back, because of having to keep the Liberal Democrats happy, they will be under pressure from financial markets to produce a victory as soon as possible.
See how the pound has been holding up:
Click Image to Enlarge
Last week not only raised the risks for sterling, it also raised the stakes for sovereign debtors in general as Greece's rescue package from the European Union and the International Monetary Fund failed to boost the confidence of the international investment community.
Since then, the EU and the IMF have announced a possible EUR750 billion emergency funding facility to help prevent contagion from Greece, but this won't make it any easier for Greece to impose the onerous austerity policies it must pursue to prevent default.
As a result, countries such as the U.K. have come even more under the fiscal spotlight. This has already started to widen yield spreads and raise borrowing costs.
At the same time, there is the risk of a credit downgrade.
If the new U.K. government, whatever its final structure, looks unable to cut spending and reduce the deficit fast enough, then the country's triple-A rating will swiftly be lost.
In recent weeks, as the major agencies have slashed the ratings of euro-zone debtors, they have made it clear that the U.K. is unlikely to be spared once the election is over.
Moody's may have helped to calm initial concerns with an assurance Friday that the election results don't threaten the country's debt rating.
But the shape of the coalition and its ability to impose policy has yet to be tested.
There are two other reasons why sterling's recent decline will continue.
The need for fiscal tightening will ensure that the Bank of England's monetary options remain limited as the country's already-fragile economic recovery shudders nearly to a halt once again.
Economists at ING Financial Markets said that instead of growing at 3-4% as the government has forecast, the economy is more likely to expand by only 1-2%.
With interest rates likely to remain down at current levels at least for the rest of this year, any hopes of some sterling support from yield differentials is pretty slim.
Of equal concern for sterling investors is the political uncertainty that the inconclusive election results have ushered in.
Even a Conservative-led government under David Cameron, which might be seen as marginally more fiscally responsible, could prove highly unstable.
The U.K. has a poor history of ruling coalitions and fears of another early election will make sterling assets even more of a liability.
"This would be seen as one of the worst possible outcomes by the market and will see sterling come under significant pressure," warned Hans Redeker, head of global foreign exchange at BNP Paribas in London, as he slashed his forecast for the pound down to $1.28 by the first quarter of next year.
Early Monday, the pound was getting a little relief as the coalition negotiations drag on and Cameron edges closer to becoming prime minister. By 0645 GMT, the pound had risen to $1.4863 from $1.4800 late Friday in New York, according to EBS.
The euro, meanwhile, got a big lift from news of the emergency package, which was accompanied by a decision by the Federal Reserve to reopen dollar swap arrangements with other central banks that will help ensure that liquidity doesn't dry up because of lending fears.
The single currency rallied sharply to $1.2975 from $1.2732 and was at Y120.68 from Y116.71. The dollar is also up at Y93.02 from Y91.70 as global investors display a greater appetite for risk.
Before last week's election, there was still some hope that an outright Conservative victory would bring a swift deficit reduction plan that would convince financial markets and prevent a downgrade of the country's credit rating.
The actual result, leaving the country with a coalition government that could easily fall apart and force another early election, is the worst of all worlds.
At the moment, Conservative leader David Cameron is still struggling to negotiate a deal with the Liberal Democrats, while Labour Prime Minister Gordon Brown remains in Number Ten hoping to step in and preserve his premiership if the Cameron talks fail.
Not only will either Cameron or Brown be required to fight the country's biggest fiscal battle with one hand tied behind their back, because of having to keep the Liberal Democrats happy, they will be under pressure from financial markets to produce a victory as soon as possible.
See how the pound has been holding up:
Click Image to Enlarge
Last week not only raised the risks for sterling, it also raised the stakes for sovereign debtors in general as Greece's rescue package from the European Union and the International Monetary Fund failed to boost the confidence of the international investment community.
Since then, the EU and the IMF have announced a possible EUR750 billion emergency funding facility to help prevent contagion from Greece, but this won't make it any easier for Greece to impose the onerous austerity policies it must pursue to prevent default.
As a result, countries such as the U.K. have come even more under the fiscal spotlight. This has already started to widen yield spreads and raise borrowing costs.
At the same time, there is the risk of a credit downgrade.
If the new U.K. government, whatever its final structure, looks unable to cut spending and reduce the deficit fast enough, then the country's triple-A rating will swiftly be lost.
In recent weeks, as the major agencies have slashed the ratings of euro-zone debtors, they have made it clear that the U.K. is unlikely to be spared once the election is over.
Moody's may have helped to calm initial concerns with an assurance Friday that the election results don't threaten the country's debt rating.
But the shape of the coalition and its ability to impose policy has yet to be tested.
There are two other reasons why sterling's recent decline will continue.
The need for fiscal tightening will ensure that the Bank of England's monetary options remain limited as the country's already-fragile economic recovery shudders nearly to a halt once again.
Economists at ING Financial Markets said that instead of growing at 3-4% as the government has forecast, the economy is more likely to expand by only 1-2%.
With interest rates likely to remain down at current levels at least for the rest of this year, any hopes of some sterling support from yield differentials is pretty slim.
Of equal concern for sterling investors is the political uncertainty that the inconclusive election results have ushered in.
Even a Conservative-led government under David Cameron, which might be seen as marginally more fiscally responsible, could prove highly unstable.
The U.K. has a poor history of ruling coalitions and fears of another early election will make sterling assets even more of a liability.
"This would be seen as one of the worst possible outcomes by the market and will see sterling come under significant pressure," warned Hans Redeker, head of global foreign exchange at BNP Paribas in London, as he slashed his forecast for the pound down to $1.28 by the first quarter of next year.
Early Monday, the pound was getting a little relief as the coalition negotiations drag on and Cameron edges closer to becoming prime minister. By 0645 GMT, the pound had risen to $1.4863 from $1.4800 late Friday in New York, according to EBS.
The euro, meanwhile, got a big lift from news of the emergency package, which was accompanied by a decision by the Federal Reserve to reopen dollar swap arrangements with other central banks that will help ensure that liquidity doesn't dry up because of lending fears.
The single currency rallied sharply to $1.2975 from $1.2732 and was at Y120.68 from Y116.71. The dollar is also up at Y93.02 from Y91.70 as global investors display a greater appetite for risk.
- 10 May |
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