By Jason Gaywood, consultant, HiFX

Domestic politics rather than EU crisis may be cause of Sterling downfall, argues Jason Gaywood, consultant at currency specialists HiFX.

The long awaited EU Summit turned out to be something of a damp squib. Cameron’s veto being the most newsworthy event that in reality saw little progress in terms of solving the Eurozone’s burgeoning debt problems. Yes, there is a treaty to increase fiscal integration. Yes, there is a 26 nation “accord” aimed at preventing a repeat of the current crisis. What there isn’t though is any more ‘real money’ to ease the difficult passage of Italy, Greece and others through a necessary period of austerity. Once again, the can has merely been kicked further down the road. The IMF itself highlighted over the weekend that there is, as yet, no viable solution to the EU Sovereign Debt Crisis.

Amid all the rhetoric, currency volatility has been remarkably benign — with Sterling Euro rates being trapped in a two cent range since the beginning of November. Some argue that this is the calm before the storm and it would seem logical that we should witness some sort of ‘breakout’ move once there is greater clarity as to whether the Euro will survive this episode or not. The direction of this move remains finely balanced - the lack of volatility masks a huge amount of uncertainty within Financial Markets.

The UK’s veto may, however, provide the indirect impetus for a Sterling based move. Not because of what it signals about our stance in the EU or what it means for the safeguarding of the City of London but rather what it could mean for the current coalition Government. Cameron’s resounding ‘No’ has stirred up something of a political hornets nest — winning praise and adulation from Conservative Eurosceptics and simultaneously attracting broad criticism from the Liberal Democrats who have always been very pro Europe. Nick Clegg, the Leader of the Lib Dems and Deputy Prime Minister to David Cameron has publicly stated that he is “bitterly disappointed” by the veto and that it is “bad for Britain”. The obvious rift threatens to expose deeper differences and unleash simmering disquiet on both sides. This in turn could increase the likelihood of a full blown break up of the coalition and heighten the prospect of an early general election in the UK during 2012.

Financial Markets hate nothing more than uncertainty and have a nasty habit of harshly punishing it severly. Recent examples being the dramatic increase in Bond Yields (cost of borrowing) for both Greece and Italy immediately prior to the ousting of Prime Ministers Papandreou and Berlusconi. Since then, despite little tangible improvement, the yields have fallen away. If we turn attention the UK, whilst it is unlikely that political uncertainty will affect the cost of borrowing, it could very well adversely affect demand for and therefore the value of Sterling. If we cast our minds back to all the political wrangling in the run up to the last election and the period of limbo between the result and the formation of the current coalition, The Pound weakened by 6% against the single currency and by a similar amount against the Dollar. A move like that today would take GBPEUR from 1.1700 to 1.1000 and GBPUSD to 1.4600. Import prices and therefore inflation may well increase dramatically if a Tory/Lib Dem split opens up over Europe.”

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