MARKETS LIVE BLOG: GBP/USD Volatility to Rise Amid Election Speculation

Key Takeaway

• UK election speculation for early July has increased two- and three-month implied volatility for GBP/USD, with a notable spike in two-month volatility.
• The pound is up 1.7% against the dollar in May, driven by softer US yields; upcoming UK inflation data could influence its trajectory.
• April's higher-than-expected UK inflation at 2.3% year-over-year has dashed hopes for BOE rate cuts in June, impacting gilt yields and market expectations.

UK Election Speculation

Speculation around the timing of the UK general election is intensifying, with several media outlets suggesting early July as a potential date. This speculation has started to influence volatility markets, particularly measures of two- and three-month implied volatility for the pound against the dollar. These measures, which protect traders against swings in the currency pair, have shown a slight uptick this afternoon. While the moves are not substantial, they represent the most significant increase in about a month. Shorter-term contracts, however, have not shown similar movements, indicating that the market is primarily reacting to the potential election timing.

Prime Minister Rishi Sunak's decision to announce an election on July 4 has surprised the markets, leading to a spike in two-month volatility on sterling. Market odds show overwhelming conviction that Labour will form the next government. A September survey indicated that professional investors believe such an outcome would be beneficial for both UK stocks and sterling. Given this sentiment, it would take a surprise outcome to move the pound beyond its 1.2300-1.2894 range seen this year.

Pound's Strong Performance in May

The pound is on track for its best month since November, having strengthened by 1.7% against the dollar so far in May. This performance is atypical for the currency, which has only seen appreciable gains in May once in the past decade. The recent strength of the pound is largely attributed to softer nominal and inflation-adjusted yields in the US. However, the pound's trajectory could be influenced by the upcoming UK inflation metrics. Headline inflation in the UK is forecast to slow to 2.1%, but core prices are expected to remain above 3%, and the services metric is anticipated to stay above 5%.

If the inflation readings are milder than expected, it could lower inflation-adjusted yields and check the pound's progress. Conversely, stickier inflation prints could lead traders to become more skeptical about the prospect of the Bank of England (BOE) loosening its policy, providing further impetus for the pound. Two-month volatility pricing is now around 6.23%, reflecting that options traders are priced for GBP/USD to swing between 1.2386 and 1.3072 over the period of expiry.

UK Inflation Data Surprises

The latest UK inflation data for April has surprised markets, coming in higher than expected and dashing hopes for premature rate cuts from the BOE. Headline inflation matched the highest of street expectations at 2.3%, while core inflation remained close to 4%. Services inflation, a key concern for the BOE, stayed stubbornly high at 5.9%, barely moving from the 6% level it occupied in March. The higher-than-expected inflation figures have significant implications for the BOE's monetary policy. The prospect of a rate cut in June, which was previously priced at 55%, is now seen as highly unlikely. Market expectations for cumulative rate cuts in 2024 are also expected to mellow, moving towards one-and-a-fraction cuts.

The pound also reacted to the inflation data, spiking to the day's highs as the slower-than-expected easing of inflation caught traders off guard. April's Consumer Price Index (CPI) rose 2.3% year-over-year from 3.2%, compared to a 2.1% estimate. On a month-over-month basis, CPI slowed to 0.3%, compared to a 0.1% estimate. The sticky services CPI, which rose 5.9% compared to a 5.4% estimate, is a particular concern for the BOE. Governor Andrew Bailey had previously remarked that the BOE was expecting "quite a drop" in April inflation, so the higher-than-anticipated figures puncture the best-case scenario for markets. "This set of data will scupper hopes for a rate cut in June," noted Ven Ram, a Bloomberg analyst. "Given UK inflation has overshot the Bank of England’s target for so long, today’s data for April will capture the markets’ imagination."

Impact on Gilts and Market Reactions

The unexpected inflation data is likely to trigger a selloff in front-end gilts when markets open. Two-year gilts, which have been trading relatively rich compared to the BOE's implied rate trajectory, are expected to see yields rise by up to 10 basis points on the day. Analysts predict that yields may eventually settle around 4.65% within a week. The market reaction to the inflation data underscores the sensitivity of gilts to inflation expectations. If inflation had come in line with forecasts, gilts might have attempted an initial rally, but any gains would likely have been short-lived given the current pricing for two rate cuts this year. Conversely, a significantly lower inflation reading would have emboldened traders to bring forward pricing for a first rate cut to June and factor in more substantial cumulative loosening through the year.

A key risk to the view is the possibility of spot breaching, ironically, the upside pricing implied by options volatility. Any sudden sign that the US economy is turning pear-shaped will send nominal and inflation-adjusted yields lower there, which will send GBP/USD higher. Spot sterling is less than 3% away from that upside.