The hotly contested U.K. elections are turning into the storm before the calm for currency traders.
While a measure of expected volatility in the pound just after the U.K.’s May 7 elections surged to a five-year high, a longer-term gauge has tumbled. Sterling is also becoming more popular with forecasters, suggesting the risks posed by a too-close-to-call vote are seen as manageable.
“The pound could be in for a bounce after the election,” said Valentin Marinov, head of Group-of-10 foreign-exchange research at Credit Agricole SA’s corporate and investment-banking unit in London. “The whole uncertainty will likely abate. The economy is continuing to do rather nicely.”
Opinion polls have the leading Conservative and Labour parties running neck and neck, and both have pledged policies criticized by business leaders. At the same time, Britain’s economy is forecast to grow faster than most of its Group of 10 peers, while the Bank of England looks set to boost the pound’s allure by becoming the first major central bank after the Federal Reserve to raise interest rates from near zero.
Those push-and-pull factors are playing out in the price of options used to insure against volatility in the pound versus the dollar.
The gap between the outlook for price swings in one month and those in six months jumped last week to as high as 2.5 percentage points, the most since the run-up to September’s referendum on Scottish independence. That suggests traders expect short-term gyrations to settle down after the election.
“On Scotland, the FX market woke up very late,” said David Bloom, global head of currency strategy at HSBC Holdings Plc in London. “This time the options market woke up too early and started pricing in the risk of a big sterling move.”
Strategists surveyed by Bloomberg predict Britain’s currency will strengthen versus all but two of its 16 major peers by the end of the year. In mid-February it was forecast to weaken versus all but five.
For now, the approaching election is stymieing gains achieved by the pound in recent months.
Sterling surged to an almost six-year high versus a basket of G-10 currencies tracked by Bloomberg Correlation-Weighted Indexes in March, and has since tumbled 3 percent.
Britain’s currency has also fallen about 3 percent from its seven-year high of 70.14 pence per euro reached on March 11. It sank to $1.4566 last week, the weakest level since 2010, and was at $1.4918 as of 8:40 a.m. in New York.
Credit Agricole’s Marinov sees sterling approaching $1.57 and 67 pence per euro by year-end as the political risk dissipates. Bloom of HSBC puts “fair value” at about $1.55, almost 4 percent stronger than current levels.
Not everyone’s as optimistic.
“There’s just too many questions with the election,” said Chris Gaffney, president at EverBank World Markets in St. Louis. “I still would not invest into the pound sterling at these levels.”
Risks surround all three of the most likely outcomes of next month’s vote: an outright victory for the Conservatives would precipitate a vote on Britain’s membership of the European Union; a Labour win would spell a wider deficit for longer and more regulation on business; and a minority government or coalition may lack stability.
Once a new administration is formed, traders speculate that any risks from policy will be outweighed by a potential increase in the U.K.’s 0.5 percent main interest rate. While forward contracts show investors are all but ruling out higher borrowing costs before the middle of 2016, they still put Britain on a path to increasing rates less than a year after the U.S.
Growth will also help as economists in Bloomberg surveys predict U.K. gross domestic product will expand 2.6 percent this year, compared with 2.1 percent across the G-10. According to the most recent labor-market report before the general election, jobless claims fell to the lowest in four decades in March.
Improving growth in the euro zone may stoke Britain’s growth further because it’s the group’s biggest trading partner, and this may accelerate the timing of a rate increase, said Jens Nordvig, managing director of currency research at Nomura Holdings Inc. in New York. His bank predicts sterling will weaken to $1.46 by December.
“It’s tempting to get very bearish on sterling because of the election but my experience with trading around political dynamics is that they often get overpriced,” Nordvig said. “A BOE hike could be pushed forward. That’s something that’s worth thinking about.”