Surging GBP volatility ahead of UK Election Day

The simplified implications that a Tories victory is good for financial markets and investors over Labour is being complicated by the sobering reality that neither party is likely to win a majority. Another five years of coalition government is unavoidable. Uncertainty is stemming from not knowing which party will win the most seats; what coalition will form a majority or minority government; and the actual reaction in currency and equity markets are contributing to unprecedented levels of volatility in the British pound.

The possible downside and upside risks for sterling and the FTSE-100, associated with a Labour-SNP victory and an outright victory by Conservatives have been discussed in previous election/markets pieces.

Sterling’s political risk premium

A popular means of measuring volatility in currency markets is the expected future volatility of a currency over a specified period of time. Charting the one-week implied volatility for GBP/USD reveals the close relationship between GBP/USD’s spot price and heightened fears weighing on the currency pair.

The charts below highlight the predominantly inverse relation between GBP/USD and one-week volatility in each of the recent major episodes of surging volatility. The deepening sell-off in global markets on October 2008, resulting from the escalation of the housing/subprime crisis, and the uncertainty from the 2010 UK General Election have acted as tremendous triggers for sterling volatility. Most specifically, GBP/USD tended to lead rallies in volatility by 2-4 weeks.

Ahead of the current Election uncertainty, GBP 1-week volatility has soared to 18.7, surpassing the highs from Scotland Independence Referendum in September and reaching levels not seen since the 2010 Election in 2010.

The most likely risky scenarios

Out of the various election scenarios, the following are the most likely (and realistically) to trigger prolonged volatility in the markets – especially the pound:

- Conservatives win the most seats, are unable to gather majority with the help of Con-Lib coalition and fail to obtain a vote of confidence from MPs on the Queen’s Speech (presenting Tories’ legislative programme). In this case PM Cameron would have to resign.

- A Labour victory via a minority government with the support of the Scottish National party and Liberal Democrats and other smaller parties (Cymru, Greens), gaining sufficient seats to vote down Cameron’s Queen’s Speech and placing Ed Milliband as Prime Minister.

- Labour gains minority victory, but Milliband Queen’s Speech is rejected at the House of Commons, thereby sustaining defeat to Labour and another election will have to be called, most likely in autumn.

Conservatives-EU Referendum link

As long as none of these scenarios eliminate the risk of holding a referendum on the UK’s status in the EU, the risk of Britain’s exit (Brexit) will cast a shadow on the business confidence, sterling and gilts. Despite Conservatives’ market-friendly policies, victory for PM Cameron would be synonymous with “Brexit” risk, as the Party is committed to hold an EU referendum by the end of 2017. The repercussions of a Brexit would be damaging for the UK economy and market confidence, considering the UK’s role as a destination for large and medium sized global businesses, which export to other EU countries.

GBP traders are well aware that the leading credit agencies (Moodys, S&P and Fitch) have raised the likelihood of a downgrade in Britain’s sovereign rating in the event of a Brexit.  And if a referendum was voted to keep the UK in EU by a sufficiently close margin, then lingering fears of renewed referenda could create a lingering EU-risk premium, prompting businesses to leave the country as was the case in uncertainty-hit Quebec in the mid-1990s.

Although the latest chart formations of GBP/USD one-week volatility (from momentum oscillators) are nearing overvalued levels, a protracted run-up towards the 2010 highs (above 23-25) suggest that GBP/USD remains at risk to a violent bouts of volatility, with GBP losses most likely to occur against AUD, CAD and JPY, while the neutralisation of Election risk is most likely seen benefiting GBP against USD and NZD.