U.K. General Election result should drive direction of the Pound

This morning there was an interesting debate on CNBC after the future direction of the British Pound versus the Euro. The Euro has been under pressure over the last few weeks as Ireland, Portugal, Spain and particularly Greece struggle with huge budget deficits and sharply declining GDP’s.

If the Bank of England decides to maintain rates at 0.5% despite the worrying inflation numbers released for December, the pound could come under pressure as other economies raise interest rates faster as their growth recovers faster. This is already happening in Australia and although the U.S. Federal Reserve seems to be reluctant to raise interest rates in 2010, 2011 may be a different scenario particularly if U.S. treasury auctions to fund the huge budget deficit start to become difficult.

Both the Labour government and the Conservative opposition in the U.K. acknowledge the current budget deficit needs to be tackled but detail on is scant as the Election looms this summer. VAT moved back to 17.5% from 15% in January and several tax increases are due to hit in the next financial year starting April but the deficit remains a significant concern for the U.K. economy. The issue of government debt (Gilts) to fund this budget deficit has been supported by the Bank of England’s Quantitative Easing (QE) programme, but this will come to an end this year. In Q3 2009, the Bank of England bought some £97 billion in Gilts as part of QE.

The risk is that this Summer’s General Election will produce a Hung parliament where no party has an overall majority and this will slow down efforts to bring down the deficit. If this happens there will be a double whammy as Gilts continue to be issued and QE slows down to soak up the issue of this debt. The price of Treasury’s will fall as demand drops for these securities and the yield will rise. If the deficit is not dealt with quickly, there is a risk of Credit Rating Agency downgrade, reducing the U.K., triple A rating which again would push Treasury’s lower and the pound. A clear Conservative party win should reassure investors and drive Sterling and government debt prices higher. Therefore the future direction of the Pound seems linked not only to the future movements in Interest rates but are intrinsically linked to the Election. Uncertainty spooks investors, and a party without a clear electoral mandate through a majority in Parliament may be bad news for investors in Sterling.