UK Government Bond Gilts, the Election and the Euro zone

By: Seven_Days_Ahead

(Written BEFORE the Elelction)The Macro Trader’s view:

Today the UK votes in the closest fought General election campaign in living memory. With a hung Parliament still looking the most likely outcome, at least according to the opinion polls, we look at how the Gilt might react once the results are known.

We judge there are three possible scenarios:

1. The Conservative party wins an overall majority.
2. The Conservative party is the largest party, but needs the support of the Ulster Unionist to achieve a working majority, and
3. The Conservatives or Labour emerge as the largest party, but need the support of the Liberal democrats to secure a working majority.

Under Scenario 1 we judge the Conservative party would indeed cut the deficit more aggressively than current Government plans. Their main focus would be public spending cuts. This would have two economic affects; the recovery could initially weaken before speeding up later, and the Bank of England would leave interest rates on hold throughout the year as they would expect inflation to correct lower. This scenario would be the most bullish for the Gilt. Since it would only be adding to the existing bullish impact of the Gilt’s safe haven status resulting from the Greek debt crisis.

Under Scenario 2, we still judge the Conservative party would seek to cut the deficit faster than under current government plans and the implications for the Gilt and interest rates are eventually the same, but there could be a short-term loss of confidence if negotiations to either form an official coalition or a looser agreement take time to conclude.

Under 3, we judge the outlook for the Gilt to be negative. The price for securing a coalition agreement would be policy set at the lowest common denominator, which is effectively the current government’s deficit reduction projection.

The markets are unimpressed with these plans, so too are the rating agencies and so too is the EU Commission. With the budget deficit to GDP around 12-13% and debt to GDP projected to rise to between 70 – 80%, the UK would probably lose its AAA credit rating. The increased interest rate burden would make the deficit worse, the Gilt and Pound would come under pressure and the Bank of England would judge that interest rates needed to rise sooner than they had previously assumed.

In short, UK public finances are in a mess. The markets and credit rating agencies are holding fire to see who wins the election; hoping for a Conservative victory. If it doesn’t come, note well what has been going on inside the Euro zone. The Gilt has benefited over the last few weeks because the UK is outside of the Euro zone, but unrevised deficit reduction plans would cause a major rethink.

Until the election result is known and the shape of policy to come is revealed, possibly several days yet, we think this market could be very volatile.

The Technical Trader’s view:

Mark Sturdy
John Lewis

Seven Days Ahead
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Mark Sturdy, John Lewis & Philip Allwright, write exclusively for Seven Days Ahead a regulated financial advisor selling professional-level technical and macro analysis and high-performing trade recommendations with detailed risk control for banks, hedge funds, and expert private investors around the world. Check out our subscriptions.

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