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    UK election stress and GBPUSD

    Tonight the UK gets ready for its first multi-party debate of the UK election cycle. With voting in a little over 1 months’ time, the 7-party line up for tonight’s debate is symbolic of the uncertain election outcome. While the UK tries to make up its mind about who to vote for, the financial markets don’t seem to be immune to potential election distress.

    A couple of things suggest that the market is starting to get concerned about UK political risk including:

    1, GBPUSD options activity shows that there is a high number of expiries occurring on the 7th May (Election Day) and the day after 8th May, when the horse trading will begin if the large political parties don’t win enough seats in the Houses of Parliament to form a government on their own. (This info is provided by Bloomberg). See figure 1 below.

    2, Volatility in GBPUSD options expiring in 3 months’ time is at a 4-year high, and has been steadily rising as we move into UK election season. This compares with USDJPY, where volatility has moderated (see fig 2). The pound is one of the most volatile currencies in the G10 as we lead up to polling day on May 7th.

    So how does this compare to the last election in May 2010?

    Back then the election field was much smaller; however, the Conservative Party did not win enough seats to form a government. This left a tense few days where it tried to form a coalition eventually managing to form one with the Liberal Democrats, which was successful and lasted the entire length of this Parliament.

    Back then GBPUSD volatility was approx. at the same level as where it now (12%) before jumping sharply after the poll when no party won a large enough majority. Volatility peaked at nearly 17% in the two weeks after the election during: 1, the forming of a coalition, 2, the Tories emergency Budget which laid out the full extent of how woeful the UK’s finances actually were.

    History never repeats itself exactly, and this time things are different:

    1, On the plus side, the UK’s finances are better than they were in 2010 and the economy is growing again.

    2, But, potentially worse for sterling is that forming a coalition could be much harder as there are a proliferation of smaller parties this time round.

    What to expect after this election:

    While the economy is in better shape in 2015 compared to 2010, the potential election outcome is much more uncertain. Next week sees the release of our UK election special report, so watch out for it to get a deeper insight into the potential political outcomes from this election and what they may mean for financial markets.

    However, there are a couple of things to note:

    1, We would expect GBPUSD volatility to surge in the days after a hung parliament. This could weigh on the pound, especially if none of the major parties are able to form a coalition, leading to a re-election down the line. This could be the UK’s Lehman’s moment, and GBPUSD could fall back towards the post-Lehman low of 1.35.

    2, The flurry of options expiries, as you can see in figure 1, could add to the downward pressure on the pound from May 7th, making any potential sell off even worse. Thus, we would expect the market to spurn the pound in the days before the election, and going long the pound may only be for the very brave.

    Figure 1:

    Source: Bloomberg and FOREX.com

     

    Figure 2:

    Source: FOREX.com

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