Special Report-UK election, GBP and a Conservative victory
Tuesday, May 4th, 2010Ahead of Thursday’s UK general election GBP has traded mostly sideways in a narrow range as investor’s debate the potential impact of the UK election on the UK budget outlook, sovereign debt rating and BOE monetary policy. The financial press is filled with reports that the UK election is too close to call and that the election could result in a hung parliament. A hung parliament is thought to make it less likely that the new UK government will take quick action to reduce the record UK deficit. Failure of the UK government to take quick action on deficit reduction could lead to a downgrade of the UK AAA sovereign debt rating. It’s hard to see how the threat of a hung parliament has not been discounted by recent GBP price action. How the new parliament approaches the need for deficit reduction is key to GBP price outlook.
 All three of the major UK political parties agree on the need for UK debt reduction and the UK Treasury’s assessment of how much deficit reduction will be needed. UK 2010 budget deficit is forecast at 11% of GDP. In light of the Greek crisis, ratings agencies may be more trigger-happy which increases the risk of a sovereign debt downgrade if UK budget deficit reduction does not quickly emerge after the UK election. The speed with which the new UK government tackles the UK deficit will be the main focus for the GBP. The three major UK political parties are the current ruling Labor Party, the main opposition Conservative Party and the Liberal Democrats. The parties have proposed different ways to address the UK budget deficit.
 Conservatives want to begin reducing the deficit this year, the Liberal Democratic Party and the Labor Party want to wait until 2011 because they fear that a reduction now could threaten the economic recovery. Deficit reduction will require painful choices on spending cuts and raising taxes. The three major parties differ on how much to cut spending and raise taxes. The Conservatives want to cut expenditures more than raise taxes. Labor and Liberal Dem’s would rely more heavily on tax hikes. The latest UK election polls suggest that the Conservatives may secure a slight majority in parliament. The Conservatives are expected to take quicker action to reduce the UK budget and rely less on tax hikes. A slight Conservative majority would be a modest positive for the GBP.
If the UK election results in a hung parliament the short-term impact of the election for the GBP may be limited. The last time that the UK election resulted in a hung parliament was in 1974. GBP appreciated approximately 4% versus the USD in the months following the UK 1974 election. This suggests that the size of the UK government majority is not a major negative for the GBP. In fact since 1974 GBP has strengthened after six of the last nine general elections despite the size of the parliamentary majority. Lack of a UK parliamentary majority does not necessarily equate to weak government. The three major UK political parties are keenly aware of the need for UK deficit reduction. Some form of coalition government is likely to emerge that will agree to take action to reduce the UK budget deficit.
 The impact of the UK election for BOE policy is less clear. Recent UK economic data points to strengthening of the UK recovery with rising inflation. How quickly the new government is formed and the details of government’s plan to address the UK record deficit will be key to BOE policy outlook and the UK sovereign debt rating. If the UK election results in  a coalition government that plans to take quick action to reduce the deficit the BOE may extend accommodative policy longer to help offset the drag to the UK recovery from reduce fiscal spending. This would be a modest negative for GBP based on yield differential but a positive because it would reduce the risk of a debt downgrade. If the UK election results in policy paralysis the BOE may more quickly move towards normalization of monetary policy to try and contain inflationary risk. Normalization of BOE policy would be a mild positive for the GBP but it would be offset by the increased threat of a UK debt downgrade. BOE policy may have less impact on GBP then the deficit outlook.
 The financial press has been forecasting that the UK election would result in a hung parliament. GBP remains remarkably stable despite this forecast GBP has is supported by expectation that election could result in a modest majority for the Conservatives or coalition that is wiling to work on deficit reduction. Investors will be looking for how quickly the three UK political parties form a new government and take action to reduce the deficit. Former UK Exchequer Lawson said that failure to take decisive action on the UK budget deficit after the election could cause major problems for the UK financial markets and GBP. Bond vigilantes may emerge as they did in the Greek financial markets. This would raise the cost of financing the UK debt and may spark selling of the GBP similar the recent decline in the EUR. The EUR traded at 12 month low versus the USD Tuesday pressured by concern about sovereign debt risk in peripheral EU countries.
 Ratings agencies are expected to wait until the announcement of new UK budget before determining whether action on the UK AAA sovereign debt rating is warranted. This suggests that the immediate impact the UK election will be limited for GBP and UK bond markets. The GBP could experience modest selling pressure if election results in a hung parliament and lack of majority. A Conservative party victory would likely be the most positive scenario for the GBP. Australian press reports that an Irish bookmaker is already paying out early on the Conservative party leader Cameron becoming the new UK prime minister.
Written by Easy-Forex
