The big news from the UK is Prime Minister Rishi Sunak's announcement of a general election on July 4th, much sooner than expected. Opinion polls indicate a likely victory for the opposition Labour Party, which has maintained a steady 20-point lead over Sunak’s Conservatives since the beginning of the year. Sterling has held its gains driven by inflation, while UK gilts continued to sell off as expectations for a Bank of England (BoE) rate cut diminished further.
Sterling surged to a two-month high of $1.2760 against the US dollar yesterday as the UK-US rate spread narrowed following the UK inflation report. Services inflation, closely monitored by the BoE, came in at 5.9% year-on-year for April, higher than the 5.4% forecast. Consequently, recent expectations for a dovish BoE rate cut were significantly reduced, with the likelihood of a June cut dropping from 50% to 10%, making an August cut seem more probable. Gilt yields rose across the curve, with the 2-year yield experiencing a nearly three-sigma move, rising by 15 basis points in a day—the largest daily increase in over a month.
The early election call by Sunak followed his declaration that inflation was “back to normal,” referencing the decrease in headline CPI from 11% in October 2022 to 2.3% in April 2024. However, persistent services inflation might delay BoE rate cuts, which explains the market's recent reaction. The lack of significant market response to the snap election highlights the greater importance of inflation and monetary policy for FX traders. Moreover, many political commentators consider a Labour victory almost certain. Despite this, the event is not devoid of uncertainty; GBP implied volatility for two-month and three-month tenors rose to multi-week highs, and risk reversals are becoming less pound bearish.
While markets typically favour continuity, a Labour government is anticipated to bring political stability. The prospect of a closer relationship with the EU under Labour could reduce some of the pound’s Brexit premium. Additionally, the party’s shift towards a more pro-business, centrist stance could further support sterling.
