Sterling whistles past the sovereign graveyard

‘A tragedy,’ Kenneth Clarke, the British Conservatives’ shadow business secretary, said.

‘A hung Parliament is instability, uncertainty, potentially higher interest rates, potentially Britain losing its credit rating,’ David Cameron, his leader, added.

‘Meh, see if I care’, said sterling.

Punters on the pound and gilts really don’t seem to mind too much that the Liberal Democrat party are leading many polls right now — even though a good Lib Dem showing in the ballot might usher in an uncertain period of coalition politics, as the Conservatives warn. (Though we rather suspect they’re talking their book on that).

This is perhaps not ideal at an acute time for UK sovereign debt, as investors who responded to a recent FT survey have feared.

Indeed, data on Thursday revealed post-war highs in UK public sector borrowing, as the FT reports. And yet GBP/USD seemed to be shrugging off any large movement as at pixel time, as the chart below illustrates:

Not bad for the Great British Krona‘s recent decline. What’s going on?

Ian Williams of Altium Securities had one answer in his note covering the election’s effect on UK equities:

Sterling won’t do what you expect

In theory the most immediate financial market ‘tell’ following the result of the election should be the reaction of sterling. As we all know, markets hate uncertainty, hence the conventional wisdom that a hung parliament outcome will prompt a sell-off in sterling. There’s not a great deal of historic precedent to help here although we note that following the February 1974 election, the last to deliver such a result, sterling rallied by close to 7% against the US dollar in the subsequent two months. That followed a period of weakness similar to that experienced over the last couple of years, which has left the “go short sterling” call as a very crowded trade. So from a technical standpoint there could be potential for the pound to bounce strongly in the likelihood of a decisive result. What happens after that depends on the development of monetary and fiscal policy.

Goldman Sachs’ Global Markets Daily team also shed a bit of light on current trading in their note on Thursday (emphasis ours):

Markets await the outcome of the second televised prime ministerial debate to be broadcast at 2000hrs BST. Given the shake-up of the two-party status quo in last Thursday’s broadcast, the debate, and subsequent reaction, has potentially led markets to expect, and possibly accept, the outcome of a joint minority government led by either of the two main parties.

It is important to note that despite the increased probability of such an outcome, rate markets have been relatively unaffected. Gilt spreads to corresponding-maturity swaps and OIS, as well as UK sovereign CDS spreads, have been trading within a fairly tight range since late February and so market positioning would already appear to be quite stretched in the direction of a ‘hung parliament’.

We have been recommending clients to position for lower risk premia in Gilt securities by being long 10-year Gilts vs short 10-yr SONIA. Of course, whether the incoming government may or may not have the strength to tackle the fiscal deficit is an outstanding issue. Yet our modelling work suggests that given the current level of deficits and sovereign credit risk, the risk premia should be considerably lower. Nevertheless, should the risk premia remain sticky, the significant positive carry on this trade is itself enough to justify the position. On the FX side we have opened short EUR/GBP yesterday on the same grounds.

Which raises an intriguing possibility: analysts have been gaming out hung Parliament scenarios for so long that markets may not be surprised by the polls’ turn any more.

Of course, there’s also a more short-term explanation.

Sterling simply looks safer next to the euro. The eurozone was buffeted on Thursday by dire Eurostat data on deficits, plus fallout from Greece. The euro is now at its weakest against GBP in 12 weeks, as Reuters reports.

But, er, about that whole fiscal adjustment thing, waiting in the corner back in Britain.

According to a Lombard Street Research report on Thursday, Britain’s parties will have to reach some way back for precedents on how to make cuts as drastic as are now required. Perhaps market confidence is misplaced, then.

As Peter Allen, LSR’s managing director, writes:

Public spending has risen remorselessly for the past 100 years with extremely rare exceptions. Real cuts, allowing for rising prices, have been almost as rare. Now it must be brought down, not just relative to GDP or in real terms, but less in cash, fewer pounds…

Public cash spending has fallen in the aftermath of wars – the Boer War, First and Second World Wars and the Korean War. Other than these episodes, one must go back to the ‘Geddes Axe’ in 1921-22 and its sequel, the ‘May Report’ in 1931 to find when public spending was seriously (some would say savagely) cut in peace time. There have also been other odd years in which cash spending fell, but few and far between. The story for ‘real’ spending after adjusting for inflation is not greatly different. After the IMF bailed out the pound in 1976-77 real spending fell but cash spending rose. This was a period of exceptionally rapid peacetime inflation.

Full note in the Long Room.

Not that we expect the Lib Dems to be uncomfortable with using history as a guide.

After all, Britain’s last Liberal budget was passed in 1909.

Related links:
[Bob and Kevin on AV] RBS’s HiPPo – FT Alphaville
Britain’s Conservatives go for the Fitch vote – FT Alphaville
UK General Election 2010 – FT / In depth