UK politicians have started the new year with their eyes firmly focused on the upcoming General Election, which will most probably be held in May.  This week’s Hoon-Hewitt challenge on Gordon Brown’s leadership has only served to increase the uncertainty surrounding the result of the General Election.

Markets hate nothing more than uncertainty and although the Conservatives are tipped to win this year’s election there is the distinct possibility of the result being a hung parliament.  In such an eventuality the correct course of action for David Cameron would be to call another immediate snap election, seeking a clear mandate from the British public.  However, politicians enter politics in order to gain power so do not expect him to risk losing his grip on power (however slender) by risking another election.  The only upside of a hung parliament would be that the very competent Vince Cable would become a Cabinet minister.

What the Gilts market (in particular) needs from this election is a clear mandate for one party to go ahead and tackle the UK budget deficit in a decisive manner for the duration of the next parliament.  With 10-year Gilts now yielding 4% and Base Rates stuck at 0.5% until at least the other side of a post-election budget (and likely a lot longer if spending cuts & tax rises are sketched out in the post-election budget – as they should be), a sharp sell-off in the Gilts market ahead of the election is not likely so the pressure will be felt most in the currency markets.  Sterling depreciating will be beneficial to the stock market as a result of translating overseas earnings and a lower currency making UK assets cheaper to foreign buyers (retailers who source their product from overseas, as well as relying on UK consumers who will likely be squeezed by a post-election budget, would miss out on this particular party).

Uncertainties about an indecisive hung parliament are likely to surface first in the currency markets and we can expect Sterling to wobble seriously ahead of the General Election.  The Bank of England is unlikely to worry too much about a further slide in Sterling unless it becomes disorderly (as the UK economy, which is still officially in recession, will benefit from cheaper Sterling), so expect parity to be tested against the Euro, although it is doubtful Sterling will stay below parity for very long.

There has been much speculation about the prospect of Tesco competing strongly with the existing UK banks as it increases its finance footprint and starts to offer loans to its customers.  Tesco already has stores spread nationwide which could serve as a branch network to the millions of customers who already shop there each week. Last year Tesco also bought out RBS’ 50% stake in their Tesco Personal Finance joint venture which means TSCO now has roughly 6 million accounts and deposits of £4.5 bln.  Today Tesco announced a deal with Fortis whereby the latter will provide motor & household insurance underwriting and claims management with Tesco doing the retail pricing and marketing.

However if we follow the money then the prospect of Tesco crushing the existing UK banks by its entry into the banking market seems less fearsome.  The big question is where is Tesco going to get the money from which it would wish to lend out to its customers?  The Bank of England (which will once again resume its proper role as banking regulator if, as currently seems likely, the Conservatives win the next election) will not allow Tesco to fund its lending via the wholesale markets (this is the business model which got Northern Rock into trouble and the BoE will not allow it to happen again anytime soon), so TSCO is going to have to compete with the rest of the banks for its share of retail deposits.  These retail deposits are highly sought after at the moment as every bank (except HSBC with its loan-to-deposit ratio of 90%) is keenly trying to increase its retail deposits so as to shift their loan-to-deposit ratios down towards 100%.  This is the structural problem in the UK banking sector at the moment – there are not enough customer deposits to go around and so most banks will continue to shrink their loan books.

The implication is Tesco are going to struggle to quickly attract tens of billions of pounds sterling in retail deposits and therefore their capacity to extend loans to customers is going to be limited to how fast they can attract deposits.  As Tesco do not intend to run their banking subsidiary at a loss (and have little experience in assessing credit quality), they are going to grow their banking business relatively slowly.  Calm down dear, its only a supermarket trying its hand at banking.  This is nothing new as the Co-op has been in the banking business since 1872 and announced recently that its customer deposits increased 21% in the first half of 2009.

The other way for Tesco to fast-track its way into banking would be to buy Northern Rock off the UK Government.  However NRK holds deposits of £19.5 bln and has a mortgage book of £66.7 bln.  However although the TSCO-to-buy-NRK deal has been rumoured, Tesco would still face the same problem of how to attract sufficient deposits to pay off the billions which NRK still owes to the BoE.  Also NRK’s loan book is said to be of low quality and questions would arise as to whether Tesco is capable of assessing NRK’s outstanding loan book, as in order to get a deal done, a significant chunk of NRK’s mortgage book would remain with the Government.

The existing UK banks needn’t spend too much time worrying about serious competition from Tesco over the next decade.

The Bank of England is likely to wait until the first Budget after the next General Election (due before June 2010) before seriously contemplating raising the Base Rate from its current level of 0.5%.

There is an outside chance Gordon Brown will call an election this autumn but it is far more likely to take place in May 2010.  The MPC will want to wait and see if taxes are raised in the new Government’s first Budget which will surely follow shortly after the General Election, otherwise the BoE runs the risk of raising rates before an election only to have to lower them again shortly afterwards to offset fiscal tightening by an incoming Government getting to grips with the budget deficit.

There is so much spare capacity be be worked through when the economy recovers that the MPC runs little risk of falling too far behind the curve by waiting until after the next election before starting to take back some rate cuts.  The MPC will surely want the economy to develop some serious momentum before risking tightening monetary policy as they will not wish to snuff out an economic recovery by raising rates too soon (which was the mistake made by the Japanese in 1997).  The MPC can easily afford to wait to see a clear turn lower in the unemployment rate without running the risk of allowing inflation to run away.

So the stage is set for Base Rates to remain at 0.5% until at least the summer of 2010.

Notwithstanding the Bank of England doing its best to inject £125 bln into the Gilts market, Gilt yields are backing up along with US Treasury yields and those of German Bunds.

There are basically two schools of thought as to why gilt yields are rising.  The more popular at the moment is that government bond investors are running scared of the deluge of supply of new government debt which is coming the market’s way over the next few years and the yield backup is a way of making room for all this new supply.  The other (less popular) explanation is that markets are anticipating economic recovery and the backup in bond yields simply represents the usual move away from risk-free assets to other more risky securities such as equities and corporate debt.

The second explanation is consistent with the rally in equity markets (with cyclicals such as retailers & mining stocks outperforming defensives such as pharmaceuticals, food processors & utilities) since early March and is also given credence by the synchronised backup in US, UK and German government bond yields.  The Dow has also broken above its 8587 May 8/20 double-top this week and is continuing the rally which started in March and which paused for breath during May (we have had two daily closes above 8587 which have negated the double-top reversal pattern).  The rally in the oil price is also consistent with an expectation of economic recovery and the only market not rallying is credit spreads.  Ordinarily these would be expected to tighten in anticipation of an economic recovery but this time it may simply be the case that banks are still not in a position to lend freely and the SIVs (which would normally be borrowing close to Libor and buying corporate bonds at wide credit spreads) are not in business any more.

Markets are clearly rallying in anticipation of economic recovery which means the rally will only be derailed by clear evidence that the economy is not recovering as per market expectations (i.e. we are still bumping along the bottom or we are going to double-dip back into a W-shaped recession); the catch is this evidence may not show up for quite a while…in the meantime it looks very much like the bears are going to be squeezed hard all summer long.