As the UK nears a General Election, all eyes remain on the economy – the key political fault line between the two major parties. Sterling is particularly in focus as the possibility of a hung parliament continues to decrease investor appetite for the UK currency. But there are some strong arguments that pessimism towards the pound is overdone.
A wide range of factors, including various potential short- and medium-term political scenarios, indicate that investors are being too harsh on the UK currency and that it is, in fact, trading well below fair value at its current levels.
Hung parliament fears
Although it is indeed possible that the forthcoming election will result in a hung parliament, some analysts suggest that the media has a vested interest in making the race appear tight to boost viewing figures and newspaper sales. By and large, a Conservative majority still appears to be the most likely outcome and at the time of writing most major bookmakers are calling an outright Tory victory.
While a strong mandate for a government committed to cutting the UK’s budget deficit would likely boost sterling, would a hung parliament necessarily condemn the pound to guaranteed weakness? There are those who argue that all the major parties will recognise the need to drop the political posturing and act on the economy, even in the event of a makeshift, coalition government.
Technical analysis
Taking politics out of the equation, it becomes clear that from a technical standpoint the pound is significantly undervalued against a range of major currencies. For instance, if you take the long-run average for EUR/GBP, the euro has been worth around 70p – currently it is around 91p. On this basis, the euro is overvalued against sterling by around 23%, once again suggesting the pound may be in line for a change of direction.
The central bank factor
Due to the large volumes traded by central banks, national currency reserves are a major driving force behind fluctuations in the forex markets. And as their economies grow, emerging market nations account for an ever-increasing portion of the global exchange of forex. Interestingly, 31% of the reserves currently held by emerging markets are in euros, while just 5% are held in sterling. This suggests that the price of sterling is unlikely to be overcooked due to these currency flows, whereas one could argue that the value of the euro is benefiting from the currency’s status as a major reserve currency.
Increased risk appetite
Finally, it is worth considering the effect that increased investor risk appetite has on sterling. While recessionary concerns tend to boost markets that are perceived to be fairly stable, gold or government bonds for example, bullish sentiment often drives upward momentum for shares and forex. And with the FTSE currently trading around an 18-month high, it certainly appears to be case that investors are becoming increasingly willing to increase their exposure to riskier markets. As such, there is an argument to suggest that the pound will eventually follow the stock market’s lead and show strong gains.
Take a position
If you have a view on what the medium- to long-term trends might be for the pound and want to take a forex position, spread betting is the simple, tax-free* way to profit from market fluctuations. You can go long or short on a range of currencies, including EUR/GBP and GBP/USD.
Find out more about forex spread betting and how to apply for an account to get started.
Updated: 16/03/10
The above comments do not constitute investment advice and IG Index accepts no responsibility for any use that may be made of them.
* Tax law can be changed or may differ depending on your personal circumstances