It didn’t take long for the pound to recover from angst over the U.K. election.
Sterling has more than regained its losses against the dollar in the week leading up to the May 7 vote and options traders are slashing bearish bets at the fastest pace since September. A measure of anticipated volatility tumbled back below its five-year average, after surging on speculation the vote would fail to produce a clear winner and lead to weeks of political horse-trading.
None of that came to pass, of course, and David Cameron’s Conservative Party won an outright majority that wasn’t foreseen in any of the major opinion polls. Even a reduction in the Bank of England’s quarterly growth forecasts on Wednesday wasn’t enough to completely derail sterling’s rebound as investors focused their attention on an economy that’s strong enough to warrant a potential increase in borrowing costs in the next 12 months.
“From now on, we’ll be focusing much more on the prospects for the economy and how that impacts on interest rates,” said Ken Dickson, the Edinburgh-based investment director for currencies at Standard Life Investments Ltd., which oversees $384 billion. “The market was definitely pricing in a large amount of uncertainty about the actual outcome of the election,” and the result “has allowed that uncertainty to unwind.”
Strategists surveyed by Bloomberg see the pound rallying versus six of its Group of 10 peers this year, including a 3 percent advance against the euro. While analysts still expect sterling to weaken against the dollar on speculation the Federal Reserve will boost rates before the BOE, they’ve raised their forecasts since the election.
The median estimate now has the pound falling to $1.48 by mid-year, up from a prediction of $1.46 in the week of the vote. Sterling climbed as high as $1.5815 on Thursday, more than 3 percent stronger than the day before the election and wiping out this year’s losses. It was at $1.5797 as of 8:45 a.m. New York time.
Options also signal more optimism. The premium for three-month contracts to sell the pound versus the dollar over those to buy narrowed to 1.2 percentage points Thursday, from 2.2 on May 7, according to risk-reversal prices compiled by Bloomberg. That’s the steepest reduction since the aftermath of September’s referendum on Scottish independence.
“It’s really been a relief rally,” said Phyllis Papadavid, senior foreign-exchange strategist at BNP Paribas SA in London. “The economic news has been quite solid out of the U.K., so now that the election risk is over, we’ll see a re-linking of sterling’s performance and the performance of the U.K. economy.”
BNP Paribas predicts the pound will appreciate to 70 pence per euro by year-end, surpassing the more than seven-year high of 70.14 set in March and up from 72.32 on Thursday. The company forecasts the currency will decline to $1.43 and sees U.K. policy makers raising rates in February.
BOE Governor Mark Carney damped the outlook for rate increases when he cut economic growth forecasts this week. Carney said the central bank will only raise its 0.5 percent main rate gradually, while endorsing investor speculation that the process may not start until the middle of 2016.
While the BOE also lowered its 2015 growth outlook, economists surveyed by Bloomberg see U.K. gross domestic product expanding 2.6 percent this year, outstripping the 2.1 percent average across the G-10.
Those economic prospects have supported the pound against most major currencies this year. A trade-weighted sterling index by Deutsche Bank AG reached the highest in almost seven years this week, after plunging before the election.
The pound’s gains may be limited if investors start focusing on a key election pledge of the ruling Conservatives: a referendum on Britain’s membership of the European Union by the end of 2017.
Sterling’s outlook “is probably not as positive” as this week’s gains suggest, and investors will eventually have to consider “what the referendum means,” said Hamish Pepper, a foreign-exchange strategist at Barclays Plc.
For now, the pound reflects optimism about the political and economic outlook that was absent a week ago. Three-month implied volatility in the pound-dollar rate dropped to 8.2 percent, below the five-year average of 8.5 and down from as much as 10.7 in the week before the election, data compiled by Bloomberg show.
Now that uncertainty has been overcome, there’s a “decent opportunity for sterling gains,” said Neil Staines, head of trading at ECU Group Plc, a London-based money manager specializing in foreign exchange. As for the negatives, the EU referendum “potentially is an issue, but it’s not today’s issue.”
For more, read this QuickTake: Britain's Multiparty Politics