With opinions polls showing neither Labour nor the Conservatives winning a majority in the UK general election on 7 May, political instability could persist well after this date.
This has negative implications for the British pound, which has been increasingly influenced by general elections in recent years.
We analysed past performance to see how elections affect the UK currency, and there is one clear conclusion: Since 1997, the pound has sold off in the two weeks leading up to the election, and the magnitude of the sell-off has increased over time. Ahead of the May 1992 election, the pound lost 0.15 per cent against the dollar while the latest election in 2010 saw a 9.17 per cent fall in the exchange rate.
Markets react at the last minute
Despite a seemingly clear pattern going back to 1997, markets have short memories. A study of the trading ranges one to three months prior to past elections showed no evidence of political risk being priced in. This suggests that markets only fully price in political risk at the last minute.
In most cases, the pound has appreciated on Election Day itself, with one notable exception: the May 2010 election that resulted in a hung parliament saw the pound lose 1.20 per cent versus the dollar on the day.
With a hung parliament looking increasingly likely, political uncertainty could be prolonged
The lesson appears to be that the pound rallies on an end to political uncertainty when a majority government is elected, while a hung parliament and intensification of uncertainty leads to a currency drop.
The 2010 coalition government, the first formed in post-war Britain, led to a 5.94 per cent sell-off against the dollar in the following two weeks, the most dramatic currency reaction recorded after any election since 1997.
This time, with a hung parliament looking increasingly likely, political uncertainty could be prolonged as a result of smaller parties playing a more significant role in parliament, or the risk of a second election before the end of the year. The 2017 EU referendum planned by the Conservatives could add further to the uncertainty.
Longer term, it’s not the same story
However, those fearing the currency impact of the election next month may wish to note that the pattern is short-lived. Extending our analysis to a three-month period after an election, we saw no conclusive evidence linking the pound’s performance to any political party or form of government.
This suggests that government policy, and not the government itself, is the more important currency driver over the longer term.
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