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Economics Weekly - What impact will the UK Election have on FX and bond markets? Weekly economic data preview - Financial markets to focus on details of Greek rescue package

Economics Weekly 3 May 2010


What impact will the UK Election have on FX and bond markets?


Prospects of a hung parliament have, until recently, weighed on the pound…

With less than a week to go before the General Election, both the pound and UK bond markets appear remarkably unaffected, despite the heightened probability of a hung parliament. In the weeks leading up to the first Prime Ministerial debate, there was quite strong evidence that an increased risk of a ‘hung’ parliament was correlated with a weaker pound. The theory is that a hung parliament is synonymous with weak government, unable to take the vital steps needed to reduce the fiscal deficit after the election.


Yet, this relationship may have changed following the first Prime Ministerial debate, when the pound stayed strong despite a fall in the Conservative lead in the polls, see chart a. The first possible reason for this is that some economic data releases, such as strong inflation figures, have supported sterling. Secondly, financial markets may have already priced in the risk of a hung parliament. Moreover, there appears to be a strong consensus among the three main parties to cut the deficit.


Historically, a hung parliament or small majority has not been negative for sterling

The last time the UK had a hung parliament after an election was in February 1974, when the incumbent Ted Heath failed to secure a coalition government, paving the way for Labour to form a minority government until another election was called later that year. In the three months following the February 1974 election, sterling actually rose 4% against the US dollar. Indeed, as chart b shows, there is actually little correlation between the size of government majorities since 1974 and the subsequent performance of the pound. In the four elections with the largest government majorities (1983, 1987, 1997 and 2001), the pound actually fell by an average of 1.3%, compared with an average rise of 3.1% in the other elections since 1974.


On average, the pound tends to strengthen after general elections, regardless of the size of the government majority. This occurred in 6 out of the 9 elections since 1974. The exceptions to this tended to be when the pound rose prior to the election, in which case it tended to fall back afterwards. As the pound has fallen about 4% in the past three months, history suggests we could see a short-term recovery after the election.


What about swaps and gilt yields? Some historical examples…

We believe economic fundamentals will drive gilt yields and swaps in the medium term. Regardless of the make-up of the next government, prospects of high and rising levels of public sector debt, a probable end to quantitative easing (which has soaked up gilt issuance in the past year) and the need for the UK to compete with other countries to finance its debt are all expected to drive gilt yields and swaps higher in the next year or two.


However, history tells us that there could be a significant short-term volatility if there is political uncertainty after the election. A few historical episodes spring to mind. The first example is the period around the February 1974 election. UK 10-year gilt yields stood at 13% in January, but rose to 13.51% by March after the hung parliament result. The spread over US 10-year treasuries rose from 601bp to 630bp over the same period.


Secondly, the surprise Conservative victory in the 1992 election resulted in a whopping 70bp fall in 10-year gilt yields and swap rates in the days after the election, reversing similar rises prior to the election – see chart c. Finally, the Conservative leadership election contest in 1995 provides an insight on the impact of political uncertainty on bond markets. During the leadership contest, 10yr gilt yields rose 50bp to 8.5% and 10yr swaps rose 40bp to 8.75%. A week after the contest in which John Major was reelected as leader and continued as Prime Minister, gilt yields fell back to 8.1%, while 10yr swaps fell to 8.4% – see chart d.


So, what could happen to the pound and swaps after the Election?

What these historical episodes show is that, in the event of a hung parliament after 6 May, we could experience a rise in gilt yields and swaps in the order of 20-30bp, but an outright Conservative majority could result in a short-term fall in gilt yieldsand swaps of a similar magnitude.


In terms of the pound, our analysis suggests that there is little correlation between sterling and the size of a government majority. The pound tends to strengthen after the election, especially if it has fallen before it. Given the need for a weak pound to help the UK recovery, this may not be good news.


Hann-Ju Ho, Senior Sector Economist


Weekly economic data preview 3 May 2010


Financial markets to focus on details of Greek rescue package


􀂄 This week’s UK calendar is dominated by Thursday’s General Election. As we note in this week’s commentary, gilt yields and the pound have so far remained broadly unaffected by the heightened prospect of a hung parliament. This is presumably on the perception that such an outcome could result in a stronger cross-party consensus on the need to tackle the budget deficit. While we broadly agree with this, the election still represents significant event risk. While the three main parties all agree on the need for fiscal consolidation, they disagree markedly on the make-up and timing of the fiscal squeeze. Given these uncertainties, gilt yields and the pound could be vulnerable to heightened volatility in the days ahead. On the data front, the main focus will be on the April purchasing managers’ surveys. We expect both the manufacturing and services PMIs to have posted a modest improvement, to 57.5 and 56.5, respectively. The April PPI figures are also due. Given the continued rise in import prices, another firm increase in producer input prices is expected. Also, the BoE will be releasing the final money supply report for March, containing the latest net consumer credit and mortgage approvals figures. While net consumer credit is forecast to have been broadly unchanged, at £0.4bn, mortgage approvals are forecast to have risen above 50k, boosted by the earlier timing of Easter and the rise in house prices.


􀂄 Last week, the stability of the euro-zone was called into question by financial markets. Credit rating downgrades for Greece (to ‘junk’ status), Portugal and Spain prompted a sharp sell-off in equity and peripheral European government bond markets. At one point, the spread of 10-year Greek government bond yields over German bunds stood at close to 850bp, although it has since eased as discussions between Greece, the European Commission, the IMF and ECB edge towards conclusion. Whatever the exact nature of the imminent emergency package, it must be sufficient to meet Greece’s debt refinancing needs but also send a strong message regarding a definite path to a more sustainable position on public finances. Any trace of moral hazard risks undermining the entire package with likely repercussions in financial markets. This week’s ECB policy meeting is likely to be notable not for an unchanged refinancing rate of 1%, but for Jean-Claude Trichet’s reaction to developments on Greece at the ECB’s press conference. In terms of economic data, this week sees the release of final April purchasing mangers surveys for the euro-zone where we look for unrevised

readings of 57.5 and 55.5 for manufacturing and services, respectively. Greece’s problems notwithstanding, recent business surveys have displayed encouraging signs, mainly on the back of improved net trade prospects.


􀂄 Following the Federal Reserve’s decision to leave the target range for the federal funds rate at 0%-0.25% and its intention to keep rates low for an “extended period”, this week sees a particularly busy US economic data calendar. Most important will be Friday’s non-farm payrolls data where we look for an increase of 190k in April, alongside an unemployment rate of 9.5%. The data take on even greater significance after the Fed’s observation that the labour market “is beginning to improve”. Thus far, the employment picture has been quite chequered with three increases and three falls over the past six months. The latest ADP employment survey is released on Wednesday, which will also provide an indication of labour market trends. We look for the “headline” ISM manufacturing index to register 60.0 in April compared with 59.6 previously. And in the services sector, we see an outturn of 56.5 against 55.4 in March. Other figures published this week include factory orders on Tuesday, along with personal income and spending data


Adam Chester and Mark Miller



Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.




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