Currency traders rush to price in UK election uncertainty

The most closely-fought UK general election in a generation has triggered the first sign of notable financial market tension, with investors clamouring for insurance against sharp swings in the value of the pound.

With less than a month left until voters mark their ballots and little separating the two main parties in the polls, the currency market has registered a pronounced rise in volatility, suggesting that investors are preparing for a period of elevated political uncertainty.

Market measures of volatility of the pound against both the euro and the dollar have reached a level not seen since the formation and first year of the current coalition government.

The currency market has often set the tone ahead of bonds and shares, as the tip of the spear for broader market turbulence - notably last year ahead of Scotland voting on the issue of independence. For now, UK government bonds and share prices have not been affected by the election campaign, but that may well change as the clock ticks down to polls closing on May 7.

"The UK political story has not really been priced in until now, " said Koon Chow, macro economics and foreign exchange strategist at Union Bancaire Privee.

"The last time we saw such a spike in implied option volatility was in the immediate run-up to the Scottish referendum. Since then, markets have been too sanguine about the political risks faced by the pound, and today we have learnt that they are rushing to catch up.''

The rise of both the UK Independence party, which advocates British withdrawal from the EU, and the separatist Scottish Nationalists has left markets wary on the implications of the poll for sterling in particular.

Investors have pushed implied option volatility over the next month for the sterling-euro pair - a measure of the cost investors are willing to pay to protect themselves between movements between these currencies - to its highest level since 2010.

A similar index measuring the sterling-dollar pair soared more than 21 per cent on Thursday, leaving this relationship at its most elevated levels sine September 2011.

For now, longer dated insurance via currency options that run for a year, have not experienced a surge, suggesting fears over the UK leaving the euro or Scotland holding another referendum on the question of independence are not worrying investors.

In a recent note on the election, Jacob Nell, analyst at Morgan Stanley, drew attention to the potential implications for the outlook for "fiscal policy, EU membership and the role of markets", and the potential knock-on effects for the UK economy.

"While we expect the recovery will continue - even in the bear case of a minority government dependent on a challenger party for support - we think this combination of factors will have a negative impact on growth, in particular via lower investment, and on the pound, given the UK's dependence on foreign inflows."

Against the dollar, the pound was down 0.4 per cent on Thursday at $1.4802, and has tumbled from $1.56 since the start of the year. The sliding pound has benefited hedge funds which placed bets via options earlier this year looking for a move towards $1.35 due to a combination of dollar strength and UK election uncertainty registering said a trader.

Sterling has fared much better against the euro as the European Central Bank has launched large scale purchases of bonds, designed to boost the economy and spur inflation, resulting in a weaker currency. The euro rose 0.1 per cent against sterling to £0.7256, but has fallen from £0.78 this year.

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