ECB Meeting And UK Election Key Drivers In Week Ahead

This week’s two main events, the ECB meeting and the UK national election have drawn investors intentions in recent weeks. The ECB may take a baby step on what promises several quarters before an exit path from its extraordinary monetary policy.   

UK Prime Minister May’s call for a snap election was seen as a strong move, taking advantage of the apparent weakness of her domestic rivals and strengthen her hand in negotiations with the EU. At the same time preventing an election that would have complicated the conclusion of the Brexit negotiations. May used the reaction to the US decision to pull out of the Paris Accord as an opportunity to put some distance between the UK and the German, French and Italian response. In recent weeks, the initial Tory lead has been whittled away to the point that YouGov is projecting it will be 18 seats shy of a majority.

In the UK the need for a coalition government is often referred to as a hung parliament. If the election does result in a hung parliament, a coalition will be particularly tricky. The tightening of the polls is not so much driven by the loss of Tory support, despite some seemingly electoral gaffes. Rather what appears to have happened is that the Labour Party is increased its support primarily at the expense of the Liberal Democrats and the UK Independent Party. The Scottish Nationalist Party may unexpectedly find itself in a position to shape Brexit, with knock-on implications for a second referendum on independence (and staying in the EU).

The Lib-Dems may be reluctant to enter into a new coalition with the Conservatives. They were decimated in the last election, and may not win sufficient seats to give a coalition a majority. The Tories had been loath to formally enter a coalition with UKIP, but post-referendum, and given the political realities, it may be reconsidered.

In foreign exchange market, the US dollar’s weakness is masking political anxiety in sterling. Sterling has lost about 4.5% against the euro in a slide over the past six consecutive weeks. It has fallen nearly 3% against the yen in the ongoing four-week drop. On a trade-weighted basis, sterling fell throughout May, losing 2.75%, before recovering a little last week. Volatility has increased (three-month implied) for the past three weeks, and the skew in the risk reversal (puts and calls) has moved sharply in favor of puts.

The FTSE 100 reached new record highs before the weekend. There seemed to be an interesting logic at work. If the election outcome was favorable than equity market would rally and the FTSE 100 would go for the ride. If the election outcome were unfavorable, sterling would be sold and this would cushion the downside of the FTSE 100 where foreign earnings are so important.