Markets underestimating potential election impact

On the whole, the consensus view in the markets still appears to be that the result of the general election will not have major consequences for UK asset prices. If markets had become concerned, then one would expect to have seen sterling weaken and gilt yields rise as investors demanded more compensation for uncertainty. But while sterling has weakened against the dollar over the last month, this appears to have reflected the bigger drop in interest rate expectations in the UK than in the US. Note too that the cost of insuring against a fall in sterling has fallen over the last month and gilt yields have continued to outperform US Treasuries. Nonetheless, we still think that asset prices could move sharply after the election. Since there are major differences regarding the size of the fiscal squeeze a Labour- or Conservative-led government would implement, and hence the speed at which monetary policy would be tightened in the next parliament, gilt yields and sterling could move sharply as the next government is formed.