Hung parliament prospects cast pall over sterling

Prospects for a hung parliament that would wreck any positive sentiment towards sterling forced economists in the latest monthly Reuters foreign exchange poll to slash their forecasts for the pound against the dollar.

Median predictions from the monthly poll of 65 analysts taken this week showed the pound rising to $1.51 in one month, a far cry from the $1.60 predicted in last month's poll in which no economist foresaw the pound slipping under $1.53.

On Monday the pound hit a 10-month low of $1.4781 after opinion polls predicted no clear winner would result from a general election to be held by June, a scenario that would leave the next government without a strong mandate to cut Britain's vast budget deficit.

Economists saw sterling faring better against the euro in 2010.

The poll forecast cable at $1.55 in six months, rising to $1.59 in 12 months. This compares to six- and 12-month predictions of $1.62 and $1.64 from February's poll.

"With political uncertainty growing over an ever narrowing margin between the two political parties adding to an already fragile economy, GBP is likely to be shunned by investors that seek economies with more clarity" said Vimal Popat at Cantor Fitzgerald.

Sterling volatility against the dollar was seen falling to 7.6 percent this month from an actual 8.6 percent in February.

The pound's weakness has become a key election issue.

The Conservatives, whose once-decisive lead over the Labour Party has shrunk to a few points, on Tuesday said a Labour victory would tip sterling into a "downward spiral". Labour accused them of talking the pound down for political gain.

DIVERGENCE

As in last month's poll, respondents saw the UK currency gaining in 2010 against the euro, which been hammered by the Greek debt crisis and growing signs of a stalling recovery.

Median forecasts showed the euro trading at 89 pence in three months, versus the 88 pence forecast in February's poll.

They predicted a level of 87 pence in six months and 86 pence in 12, compared to 87 pence and 85 pence in last month's poll.

Also growing divergences between how ultra-loose monetary policy cycles in the U.S., euro zone and Britain are dismantled will give more reasons to differentiate between the currencies. 

The Bank of England looks certain to hold interest rates at their record low of 0.5 percent at its meeting on Thursday, and is not expected to raise interest rates until the last quarter of 2010.

"With the U.S. implementing initial steps towards policy normalisation, most recently by raising the discount rate, we expect currency differentiation to remain a major theme" said Meng Jiao at BofAML.

"We would look for the 'liquidity-driven' sterling to underperform against the USD but outperform against the euro."

The 16-nation euro zone economy is expected to grow at a faster pace of 1.3 percent this year compared to 1.1 percent forecast for the UK.

But PMI surveys on Wednesday showed Britain's services sector activity, which accounts for around four-fifths of the country's output, hit a three-year high in February, whereas euro zone services growth slowed slightly.