Throughout the general election and subsequent coalition negotiations, a long shadow has been cast on events by the financial markets.

A speedy conclusion was urged lest sterling struggle to win investors confidence. Such talk echoed many of the warning about reactions to a hung Parliament from politicians and commentators prior to polling day.

For instance, Ken Clarke, then Shadow Business Secretary, warned: “The electorate will bring upon themselves the consequences of financial panic if they produce a hung Parliament or a Labour minority government. It would be catastrophic”.

With a coalition Government now secured, did the behaviour of the markets in recent days match up to the panic predicted by Mr Clarke?

Analysis

Looking at the fate of value of sterling, and the interest on government bonds in recent days, we can assess whether the grim forecasts were proved accurate.

As the graphs below show, the pound showed a downward trend against the dollar in the weeks running up to election day, with a sharp drop the day the inconclusive result was confirmed.

Despite the gains since the coalition was announced sterling is yet to make a full recovery.

In terms of gilt sales, the result was apparently less worrying. While there was a rise in the rates in the wake of the election result, the situation stabilised. A sale of gilts was successfully completed earlier this week.

So while there was an adverse reaction, did this amount to the panic we were warned about before the election, and how far can it be attributed to the election result?

One foreign exchange trader at Goldman Sachs told us the value of sterling had not fallen more than had been anticipated prior to the election.

He said: “The reaction to the hung parliament was as bad as expected. The pound fell about two per cent, and though it did climb again following the coalition deal between the Conservatives and Liberal Democrats,  people started selling once again when they when they realised this could herald a new tax on banks”.

Alan Clarke, analyst at BNP Paribas, agreed that the negative reaction simply matched expectations rather than resulting in panic.

“What we can conclude is the immediate market impact of the hung Parliament announcement was taken as bad news. The interest rate the Government has to pay on its borrowing saw a substantial rise in the immediate aftermath, and the pound weakened – it was at the sort of level I thought it would have if we got a hung parliament," he said.

Because forecasts for markets had been negative, markets were able to price in the effect of a hung parliament, rather than descending into hysteria. As Jonathan Loynes of Capital Economics told us:

“The adjustment had already come before the result and the result was widely anticipated,” he said

Beyond the initial reactions as the result became apparent, the reaction was not as bad as some of the gloomier pre-election predictions.

“There have been some minor fluctuations on different outcomes that looked more or less likely but overall nothing like the nightmare scenario that a lot people suggested it might be,” Mr Loynes argued

Even the rise in gilt yields was also “pretty temporary” despite the rise seen immediately after the election, he added.

Unsurprisingly the reaction seen in the markets was not solely down to decisions made by UK voters, but was significantly affected by the bail out deal agreed for Eurozone countries.

“It’s unfortunate timing. It’s incredibly hard to disentangle what has been happening to the gilt market, for example, in the UK from unprecedentedly huge implications of what has been going on with the European Union,” Alan Clarke said.

Indeed the situation in Europe may have actually helped stave off some of the more negative consequences of a hung parliament according to Jonathan Loynes.

“It may be that the Eurozone situation has helped to protect the UK a little bit even though we’ve got big problems, they are not as bad as those of Greece,” he said.

Looking forward

Despite the gilt sale and the sterling recovery, has the threat of the panic forecast by Mr Clarke now receded, despite warnings that markets would not back a coalition government to tackle the budget deficit?

Howard Archer, Chief Economist at IHS Global Insight sounded a relatively positive note.

“We believe that a full, formal Conservative-Liberal Democrat coalition provides the best chance that the Government can survive for an extended period and therefore form and enact a credible plan to tackle the public deficit,” he said.

Yet this alongside this guarded optimism that some of the warnings about a coalition government may yet be proved accurate.

“I think there could be further adverse reaction to the coalition government because if the market doesn’t think that there is sufficiently credible, or sufficiently aggressive, tightening of fiscal policy announced in the emergency budget, then I think we could see interest rates on Government bonds jump up, we could see the pound weaken, we could still get downgraded. So we’re not out of the woods yet.” Alan Clarke told us.

Conclusion

The evidence from the bond and currency markets shows that while there was an adverse reaction to last week’s election result, the situation did not get as bad as some politicians had forecast, largely because the markets were prepared for it.

While there may be problems further down the lines, it seems some of the grimmer warnings were perhaps misplaced.

Indeed Ken Clarke acknowledged earlier today that he had been proved wrong by David Cameron and Nick Clegg.

 
Patrick Casey