During a campaign the air is full of speeches – and vice versa.  ~Author Unknown

The stalls have been set out. The General Election is, at the most, 9 months away and with the final convention for one of the main parties taking place this week we want to take a look at the economic focus of what the leaders will be promising and whether the hot air will help to inflate or melt sterling’s value.

There are a plethora of issues that affect our national wellbeing; crime, education, the NHS, defence, immigration etc. The economy however is, rightly so, predicted to dominate the landscape with voters being encouraged to pick their next chosen government on who will dig us out of the mire fastest and with the least detriment to our personal well being.

The choice is simple: do we tax more to spend more or do we cut public spending to reduce the deficit and keep the tax levels where they are?

Gordon Brown wants the former. In his speech to the Labour conference last week he spoke of the need for higher taxes ‘at the top end’ although no levels were forthcoming, he plans to raise National Insurance by 0.5% in 2011 and draft a ‘Fiscal Responsibility Act’ in order to pay down half of the deficit in the next 4 years. He also said he aimed to cut ‘unnecessary spending’; a question of why it was being spent in the first case has not been raised.

The problems spawned from this plan are twofold: the prospects of people leaving the country due to what may be viewed as an excessive tax burden and what the expansion in spending may do to the deficit and, through that, the UK’s credit worthiness. I would not be surprised if we saw more and more higher rate taxpayers leaving the UK for the continent (especially France) over the coming year to avoid the 50% tax band that was announced in this year’s budget. Should that happen and the relative amount of government spending increases our debt to GDP ratio will soar further. We are expected to see that ratio move from the ‘Golden Rule’ level of 40% to close to 80% by 2013. These were cautious estimates before other spending priorities like Operation Panther’s Claw, a purported redesign of some of the 2012 Olympic facilities and other such events that may crop up over the next few years. S&P said in a statement in May that should the debt-to-GDP ratio move past the 80% level it would be hard to justify the UK’s AAA credit rating.

Needless to say should that level be downgraded the proverbial would hit the fan for sterling’s long term demand and prospects. We are walking the most dangerous of tightropes fiscally with a drop below that would signal nothing more than economic catastrophe for our fair island.

David Cameron on the Andrew Marr show yesterday warned that the budget deficit was a ‘clear and present danger’ to the UK economy. His plans to cut benefits in order to increase unemployment is, while harsh, probably the better plan for the country in the long term however a short term slashing of spending in a wholesale manner could actually damage the near term prospects for the pound, a view that Alistair Darling shares.

The referendum on Europe is another thing that Cameron is having to consider now and whether the vote should be retrospective or not. Ireland ratified the Lisbon treaty over the weekend and with Poland and the Czech Republic the only countries not to there is danger this could be ratified before the General Election comes around. The retrospective vote would roll back provisions, laws and directives that would in all likelihood end up being illegal anyway. A refusal of a referendum from Cameron would probably lead to the more euro-sceptic of Tory supporters to further right wing parties such as UKIP. The choice that we have to make is whether we have the stomach for the fight to change the EU from the inside or whether we burn bridges now.

Political wrangling, a negative campaign season filled with smear and accusations or, god forbid, a hung parliament would prove disastrous for the pound as the relative attraction of investing in the UK as opposed to elsewhere would diminish rapidly.

The next nine months will answer many questions: can Gordon Brown ‘do a Houdini’ and get himself out of the mess he finds himself in? Is Cameron actually the political heavyweight that his supporters believe him to be? Will the Lib Dems come to party or was their good result last election down to voter fatigue with the ‘Big 2’? Politically the UK is coming to a crossroads and unfortunately the pound is now in the crosshairs.

Trade idea of the week

This week’s trade of the week is a strategy made up of a forward for 2 months and a Convertible forward for the next 2 months . For a seller of sterling and a buyer of euros, this client took advantage of the uncertainty in GBPUSD in order to protect himself against falls whilst being able to benefit should the market turn higher. This also allowed the client to average out at a higher worst case rate than had he only have done an option.

The client was able to achieve a worst case rate of 1.59 on his forward which is completely protected and a worst case rate of 1.56 on the option which allows upside to a rate of 1.70. Should the rate touch 1.70 during the barrier period then the structure reverts to a forward at 1.56. The client’s overall hedge rate was therefore, at worst, 1.5750, above his costing of 1.55.

This strategy requires no premium, and is also relevant for sellers of sterling and buyers of other currencies. As there is a potential strengthening for sterling in the future, it provides a balanced upside for this potential, while guaranteeing a tight WCR.

Have an enjoyable week