Sterling has fallen sharply and may face a currency attack in the coming months. There are two main triggers which may set off a rapid short term decline in Sterling. Firstly the UK will have a General Election by June of this year. Whilst the Conservatives appeared to have an unassailable lead in the polls last year, they have certainly dropped the ball this year. The ruling Labour Party has now pulled to within 2 points of the Conservatives in the polls.

While either a Labour win or a Conservative win would have little effect on the value of sterling as both parties are strongly committed to cutting the budget deficit, a hung parliament would be a disaster. As the UK’s “First Past the Post” system strongly favours the largest minority party this situation is unlikely, however a lack of clear political leadership would leave sterling open to a currency attack from speculators.

The second trigger which could leave sterling highly vulnerable is a debt downgrading. The UK is running a budget deficit of 12% at the moment. This is a similar level to Greece, Ireland, Spain and Portugal. The main difference is that at present the UK is able to finance its own debt. In January, GILT issues were over-subscribed by 3 to 1 however a debt downgrading from AAA to AA would have a major impact on the price the Government has to pay to service its existing debt levels. Anything less than a clear political statement from the government to cut the budget deficit could lead ratings agencies to cut the UK’s rating.

In terms of Sterling’s outlook, any knock on effects from these issues are likely to be short term and relatively limited. Both Japan and the Eurozone have these same problems and more. Sterling has the one advantage that it is already at a relatively low level from 2009. The US Dollar will benefit in the short term as the money moves into US Government bonds. The US continues to finance a deficit as large as the UK’s and the US also has a similar chance to the UK of having its credit rating downgraded. The knock on effect of this for the US would be massive as the US has the largest holding of foreign investors in its debts.

Our view in the short term would be to stay out of any cross currency trades and wait for markets to calm down after May.