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And the winner of Thursday’s second British prime ministerial debate was… er, pass.
At least we’re getting clearer on who isn’t losing from poll indications that the May 6 election will produce a hung parliament*: Britain’s burgeoning sovereign debt.
After all, rating agency Moody’s was upbeat about the possible effect of such an outcome on Britain’s credit rating. That contrasts with the view of the Conservative party contesting the election, who have warned of Greek-style fiscal indecision. The Scottish National Party, meanwhile, absolutely welcomed the prospect.
Now BarCap’s European Credit Alpha observes that the alleged market fear of a hung parliament has been a bit hyped (emphasis ours):
The prospect of a hung parliament increases uncertainty and maintains pressure on sterling. The recent pattern has been that GBP does tend to weaken in response to headlines about fiscal policy. We would not be surprised to see further Sterling weakness, rising bond yields, and perhaps knock-on effects in credit, especially on the CDS of UK banks. However, given that the election is only two weeks away, the window for this volatility to materialise is closing.
Well, we’ve already noticed how sterling is trading in defiance of political risk.
While a hung parliament could extend volatility beyond the election, BarCap argue, the effect will last ‘not very long’, as negotiations will either work, or go back to an election again. Nor would a coalition government be any worse at deficit reduction. In fact, the response could be much swifter:
A minority government may have greater leeway to assemble a credible deficit reduction plan than one that is encumbered by expensive pre-election promises. Hung parliament or not, governments are typically tougher on deficits after elections than before. The potential for complete political deadlock and consequent absence of a deficit reduction plan should be treated as a tail risk.
Actually, BarCap’s prediction is borne out quite well by the experience of Swedish and Canadian minority governments. They both successfully dealt with very large deficits. There’s also an academic basis for effective fiscal policy under coalition government, as the London School of Economics’ Joachim Wehner outlines.
So much for the hype. What’s much more interesting is that BarCap go on to argue that a hung parliament may have little effect on the appetite for UK sovereign debt compared to global trends in credit markets. As the note continues:
There are greater risks to UK credit than a hung parliament. In our view, the biggest risk to Sterling credit is that, post-Greece, the short base moves to other fiscally-weak nations, including the UK. A hung parliament alone would not cause this, but further headlines in peripheral European countries could. On a positive note, it is not clear that the UK would necessarily be next in line as the next big sovereign short, hung parliament or not. The important supports for the UK are: 1) an independent monetary policy; 2) the ability to devalue its currency; and 3) a much longer Treasury maturity profile than most countries. Greece, Portugal, Spain, and Italy do not have (1) and (2) at their disposal, and suffer from immediate refinancing needs. Indeed, this lies at the heart of the reason that their fiscal consolidations, which are record breaking in historical terms, are going to be very challenging.
Moreover, sovereign CDS investors appear to be already short the UK and holding their positions, setting up UK CDS for a gap tighter on good news (such as a majority government or a functioning coalition) rather than wider on bad news. DTCC data show that $4bn of net notional exposure to UK sovereign CDS was taken between November and March, but has remained constant since then.
BarCap also mention that sterling credit just looks very cheap next to euro issues right now, amid strong demand overall. Meanwhile, the political risks over sterling can be hedged with cross currency basis swaps when it comes to corporate bonds.
We don’t recommend cross currency swaps for sovereigns, though. Ask Greece.
Full note in the usual place.
[*A hung parliament, for any not au-fait with parliamentary systems, can be described as "one in which no party has an overall majority...[the consequence of which is] the government will not be able to win votes to pass laws without the support of members of other parties”, according to the handy primer by the BBC on topic]
Related links: What happens if there is a hung parliament – Long Room On sovereign risk and jamón ibérico – FT Alphaville Portugal v Greece on sovereign risk – FT Alphaville Handy sovereign risk table - FT Alphaville
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