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Sterling, bonds set for swings as Brexit clouds ballot outlook

Investors are buying more insurance against falls in the pound sterling, as the U.K.'s opposition Labour Party has narrowed what once seemed an insurmountable poll lead for the governing Conservative Party in the run-up to the June 8 general election.

SNL Image

Prime Minister Theresa May has seen her Conservative Party's

once-commanding poll lead shrink in recent days.

Source: Associated Press

A YouGov poll published May 31 suggested prime minister Theresa May's Conservatives may fail to gain the parliamentary majority that polls said was a virtual certainty just a month ago, after May called the snap election April 19.

Sterling sold off sharply May 26 after a YouGov poll showed the Conservative lead over Labour had shrunk to just 5 percentage points, and it fell again May 31, giving up 0.5% against the US dollar to trade below $1.28.

The U.K.'s debt-to-national income ratio, which stands just under 90%, has been under intense scrutiny since the financial crisis, and the divergent economic plans of the two main parties will cause great uncertainty among investors should the polling remain tight.

Public spending would fall to around 38% of GDP by 2022 under the Conservatives, the lowest in over a decade, while under Labour it would rise to around 42%, the highest precrisis level since the mid-1980s, according to the Institute for Fiscal Studies.

The behavior of the pound so far in 2017 suggests a relief rally would likely follow a strong victory for May on June 8, according to Jane Foley, head of FX strategy at Rabobank, while the currency could fall on "any other outcome."

"Potentially of more immediate concern for the market would be speculation that economic reforms could be unwound under a hard-left Corbyn government and that the budget deficit will bear the brunt," she said in a May 31 note. "In our view [sterling] is unlikely to welcome a success for Labour next week despite the party’s softer position on Brexit."

The budget deficit would fall to £58 billion under Labour and £21 billion under the Conservatives by 2022, according to the IFS.

The IFS concluded that the long-run public finance challenge would "remain significant" under the Conservative party, whose plans to reduce annual net migration to below 100,000 would "weaken growth and the public finances."

But it sees particularly large downside risks in Labour's plans: "Tax measures [are] unlikely to raise anything like the £49 billion Labour wants, particularly over the longer-term."

Buying protection

While the range of potential outcomes suggested by different polls is still huge — the May 31 YouGov poll's margin for error allows for the Conservatives either losing 20 seats or gaining 15 — investors are clearly waking up to the risk of a hung parliament and the resulting uncertainty over which party would be able to form a government.

For one, they are buying more options on sterling to protect themselves against falls in the currency. Implied three-month sterling volatility was hovering around 8 on May 31, having been below 6.9 as recently as May 16, though these levels still pale in comparison to the period just before the U.K. voted to leave the European Union in June 2016, when the same measure was 18.6.

They have also sought shelter in less volatile government bonds. The UK's 10-year Gilt was trading with a yield of around 0.994% on May 31, having closed above 1.2% as recently as May 9.

"Trading in sterling has been highly correlated to the polls and I don't see that changing," said one London-based foreign exchange strategist. "If several polls have the lead in the low- or mid-single digits in a week's time we will see volatility rise again."

It is difficult for investors to know which polls to believe, especially since in the 2015 general election they largely predicted a hung parliament, where no party has enough seats for an overall majority, that did not materialize.

A Survation poll early May 30 put the Conservative lead at 6 percentage points, but an ICM poll published later that day gave them a healthy 12-point lead, which would be more than enough to deliver a majority.

Macquarie strategists said in a note that they simply "don't believe" the May 31 YouGov poll. "It’s based on a controversial untested methodology and all other polls still suggest precisely the opposite outcome," they wrote.

Hard vs. soft

Complicating the issue still further is the difference in the parties' intended approaches to the Brexit negotiations, which are due to start just 11 days after the election June 19.

May has stated she would walk away from talks with no trade deal rather than accept a bad one, while the Labour manifesto explicitly rejects leaving the EU without a deal and promises "fresh negotiating priorities" that will focus on retaining the benefits of the EU's Single Market and Customs Union.

Investors reacted to the uncertainty of the hung parliament following the election in 2015 by selling sterling, but the permutations around Brexit make the market reaction harder to call this time around.

The pound staged an impressive rally after May called the snap general election April 19, hitting a 2017 high closing level of $1.3036 on May 19, as investors bet on an easy victory for an incumbent government largely perceived as business-friendly and more fiscally austere than its main rival.

JP Morgan strategists said May 30 they saw little upside for the pound in a Conservative victory, as that result is already mostly priced in, but that the currency could be boosted if Labour were able to force a hung parliament and build a center-left coalition that supports a "soft" exit from the EU.

Labour could be seen as more able to build a coalition with either the Liberal Democrats or the Scottish National Party, which both strongly favor a "soft Brexit."