Wednesday, March 3, 2010

UK Election Update Hung Parliament Risks Rising $IBGM-LSE

UK Election Update
Hung Parliament Risks Rising

• Opinion polls suggest that the Conservative party may struggle to obtain a clear
   majority at the general election, if indeed they gain a majority at all.
• Our analysis suggests that a hung parliament, or at best a weak Conservative
   government, is by far the most likely outcome.
• A hung parliament would likely be highly unstable and would therefore make a
   credible programme of fiscal restraint extremely unlikely.
• Our fiscal premium model suggests that this is not yet fully priced into gilt yields.
• Unless we get a Conservative government with a clear majority, we think gilt yields
   will have to rise to about 4.75% and possibly higher if inflation remains a threat.

Market Implications
The implications for sterling and for gilt yields are potentially grim. On a
relative basis, the UK’s current fiscal position looks very strained indeed.
Regular readers will be familiar with our Fiscal Risk Indices for EMU
countries2; extending this to the global arena shows just how much of an outlier
the UK is in terms of the pricing of CDS spreads relative to the underlying fiscal

This apparent richness is largely predicated on the view that the UK’s AAA
rating is safe; however, as we have previously asserted3, this is far from sure.
threat of a downgrade tends to significantly increase the sensitivity of bond
yields to changes in the budget balance. At current deficit levels that could
push gilt yields sharply higher.

Our fiscal risk premium model suggests that the 10yr gilt yield needs to rise to
about 4.75% under current conditions, if the current fiscal problems are not
addressed. That, however, is assuming that the other fundamental drivers
remain stable. If the MPC is forced to raise rates in order to head off an
incipient inflation threat, however, yields would likely rise significantly further
than that.

UK Election Update Hung Parliament Risks Rising -

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