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Why European elections may not spell trouble for sterling

Looming European Parliament elections look like yet another catalyst on the list of events that could rock gilt and sterling markets. But are things as tumultuous as they seem?

The Brexit Party, which emerged seemingly out of nowhere to agitate for  a ‘no deal Brexit’ in mid-April, is dominating headlines in a contest which is starting to feel like a proxy rerun of the June 2016 vote on EU membership.

The European elections will be held on 23 May in the UK. A body with little power beyond blocking legislation, its elections have traditionally been fought on national issue battlegrounds rather than supranational populism.

And this vote is just the latest in a long list of woes to have beset British Prime Minister Theresa May.

Some six weeks after talks began with her Labour counterpart, Jeremy Corbyn, discussions have come to an end with no resolution having been reached. The government is widely expected to lose the second reading of the Withdrawal Agreement Bill that is now scheduled for the week beginning 3 June, whilst the Peterborough by-election on 6 June will be a key barometer of voter sentiment. Opinion polls now suggest that should there be a general election, May’s Conservative party would lose power, as well as over 100 seats. May looks set to step down should the government lose the upcoming vote, and Boris Johnson is hotly tipped to replace her, promising a harder version of Brexit than is currently proposed. The risks of a hard Brexit or a general election could spell trouble for the bond markets.

Yet markets have not been trading outside their recent bounds. 10-year gilt yields have remained within a 40 basis point range, as there has been little expectation of imminent Bank of England policy shifts. Yields have broadly been stable amid a global aversion to risk assets, or ‘flight to quality’.

And interest rate volatility markets show that it has rarely been cheaper to protect against a large move in yields.

Although sterling has weakened over the past week, currency markets remain relatively calm, as the premium investors have been happy to pay for put options (the ability to sell the pound at a pre-specified price when the holder chooses) compared to call options (the ability to buy the pound at a pre-specified price when the holder chooses) has fallen. This may indicate that investors’ appetite for ‘downside’ protection has diminished – in other words, that investors are less concerned that the currency’s value may plummet. It could also reflect investors’ ambivalence about buying protection against a moving target, after March’s Brexit deadline did not harden.

So, why are UK assets relatively stable?

There are two sides in every currency exchange – so, although British investors might be myopically thinking about Brexit in any GBP/USD trade, it’s worth remembering what the dollar is contending with.

International investors simply have bigger fish to fry. Trump’s recent tweets have announced an increase of tariffs from 10% to 25% on $200 billion of Chinese exports to the US, ramping up tensions with the world’s second-largest economy. Fears that Trump’s focus on renegotiating trade deals may eventually pivot to Europe leave already embattled German carmakers vulnerable (the European autos sector has already been hit by weak Chinese demand). These developments undermine the global growth picture – of which the US contributes a large part. And, unhappily for Trump perhaps, the US stock market is heavily intertwined with the rest of the world through US company subsidies and revenue streams from around the globe. Yields on US Treasuries have fallen in response, reflecting fears that a trade war-induced slowdown may lead to the Federal Reserve easing their monetary policy, with a 25 basis point cut now priced by December.

With interest rate hikes being paused in the US and UK for now, neither currency can expect the support offered by higher yields. But, as the Federal Reserve has greater room to respond by cutting rates significantly, the US dollar might be more vulnerable.

When you consider the magnitude of what turmoil in the world’s largest economies spells for investors, it’s less surprising that the UK market is shored up for the time being.