May 7, 2010 / 2:43 PM / 10 years ago

UK political instability to knock sterling lower

LONDON (Reuters) - Sterling is poised to suffer a further blow as the prospect of instability facing any new British government raises concerns over its ability to tackle the country’s ballooning fiscal deficit.

Sterling hit a one-year low against the dollar in volatile trade on Friday after poll results showed no party won an outright majority, raising the risk of a political stalemate which would hamper efforts to tackle the huge deficit.

While the opposition Conservatives were in pole position to take power with the possible backing of the Liberal Democrats, the third largest party, sterling was likely to suffer the longer Britain is without a clear idea of who will form the next government.

Even after a new government is decided investors may speculate over how stable it may be and how long it may last. This would add more downside risk to already risk-sensitive sterling, which is already under selling pressure due to contagion fears over Greece’s debt crisis.

“The clock is ticking and the market is hungry for clarity on the political front,” said Paul Mackel, director of currency strategy at HSBC.

“So long as the market remains nervous in general, sterling will remain under pressure.”

With no party firmly in a position of power, economists and political watchers suspect the next government may suffer from weakness from the outset, which may raise the possibility of another election.

Bookmakers saw a better than one-in-three chance of another British election this year, a scenario that would be likely to spook markets further and push sterling lower .

“It’s quite possible instability will persist and people will expect another election may come relatively soon,” said Paul Robinson, chief sterling strategist at Barclays Capital.

“All of which wouldn’t be good for sterling in normal circumstances and is worse given worries about Greece.”

FURTHER DOWNSIDE

Sterling has lost roughly 9 percent so far this year against the dollar, making it one of the worst performing major currencies. Its decline this week broke the currency out of the $1.48-$1.54 range it had been treading in since late February.

It reversed gains seen in late March, when escalating concerns about Greece’s deficit problems prompted some investors to sell the euro in favor of sterling on the logic that UK assets were a safer bet than euro zone ones.

These flows had dried up, analysts said, and were unlikely to return given the UK political outlook.

“Over the past weeks the peripheral crisis in the euro zone has accelerated and sterling partly had benefited from safe- haven flows,” said Chris Turner, head of currency strategy at

ING.

“But this has changed. The (political) uncertainty comes at a very bad time.”

He added that he saw the possibility that the pound may fall to $1.35 in the coming months, which would be its weakest in roughly 25 years and the risk of an upward correction was unlikely.

At the same time, technical analysts say sterling may find some support around $1.4339, which is the 76.4 percent Fibonacci retracement of the pound’s upward move in January-August 2009.

Some in the market said sterling may receive some relief if the Conservatives strike a deal to govern with the Liberal Democrats, whose leader Nick Clegg on Friday said the Tories should try to try to form the next government.

“A Conservative/LibDem coalition or alliance could be positive for sterling,” said Philip Shaw, chief economist at Investec.

“Both parties talk about cutting public spending and the need to address the budget deficit and they would have enough muscle to do that. The market believes such an agreement would be sustainable.”

Editing by Ian Jones

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