Sterling volatility jumps in run-up to UK election

Fears over how an inconclusive result at the UK general election on Thursday could destabilise the pound have reached their highest level since Britons last went to the polls in 2010.

The one-week sterling/US dollar implied volatility, a gauge that reflects anxiety over potential instability in the currency markets, has jumped up to 17.8 per cent. That level has not been seen since the last general election in May 2010, which produced no overall majority and led to several days of tense negotiations before a coalition government was formed.

The move in the gauge on Monday suggests currency traders believe another indecisive outcome will trigger twitchiness in the foreign exchange markets, as horse-trading to form a new government leaves a temporary political vacuum.

As the political parties enter their final few days of campaigning, the latest opinion polls continue to put the Conservative and Labour parties neck and neck.

Prime Minister David Cameron has already started preparing for the possibility of another hung parliament and is planning to hold talks with Liberal Democrat leader, Nick Clegg, within hours of the election results about forming a new Tory/Lib Dem coalition if he fails to win an overall majority.

Mr Clegg said over the weekend that he will hold exclusive talks with whichever party has the biggest mandate.

The move higher in the one-week sterling/US dollar implied volatility option took place in what would have been thin trading conditions because London, the main forex trading hub, was closed for a bank holiday. The three-month sterling implied volatility is considerably lower, however, suggesting traders do not think any instability will persist for long.

Sterling fell for its third consecutive session on Monday, down 0.26 per cent at 1.5108 per US dollar at lunchtime, having fallen 1.21 per cent on Friday in the wake of disappointing data that implied the UK's manufacturing sector was being held back by the strong pound, dampening demand for British-made goods in the eurozone.

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"This is in line with our fundamental view, as we expect the final run-up to the UK general election to be a source of sterling weakness given the outlook for a complicated political landscape," they said.

This does not represent an extremely bearish position, however - it is only half the net short level seen in the summer of 2013. It also partly reflects dealers' expectations of longer-term broad dollar strength.

Indeed, other market indicators suggest investors are relatively sanguine about prospects for UK assets over the longer term. Data from the Bank of England show foreign investors had a healthy appetite for UK debt in March despite nerves over the election result, buying £28bn of gilts and reversing a sell-off witnessed in the first two months of the year.

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