How the New Labour Government Could Affect the Pound

On Friday, the 5th of July, the pound rose against the US dollar and a basket of other currencies, closing that evening above 1.2800 to the dollar. Interestingly, while the pound strengthened, the 2-year and 10-year Treasury yields went down slightly, and the FTSE 100 closed down by 0.45%. This mixed performance across various asset classes provides some clues about market sentiment and the underlying reasons for the pound’s rise. The rise in the pound might also be driven by short-term volatility and large asset reallocations rather than a sustained confidence in the long-term outlook.

Mixed Market Signals

• Pound vs. Dollar: The immediate rise of the pound against the dollar and other currencies suggests a boost in capital flows into GBP. This is likely due to foreign investment moving into the UK, possibly into UK treasuries, which may explain why yields went down.

• Treasury Yields: The slight decrease in the 2-year and 10-year Treasury yields typically signals a flight to safety, where investors move towards government bonds in times of uncertainty. This suggests that while there was initial optimism, there remains caution regarding the economic policies Labour might implement.
• FTSE 100 Performance: The FTSE 100’s decline by 0.45% further highlights the market’s cautious stance. The top performers in the index were Smurfit Kappa Group PLC, up 3.5% in the materials sector, and United Utilities up around 3.45% in the water utilities sector. Smurfit Kappa is a cyclical stock, performing well in anticipation of economic growth, while United Utilities is a defensive stock, typically favored in uncertain economic climates. This divergence suggests mixed feelings among investors, reflecting both optimism and caution.

Market’s Wait-and-See Approach

The varied behavior of these asset groups indicates that the market is struggling to pick a clear direction until there is more clarity on Labour’s economic actions. Investors are likely awaiting detailed policy announcements, particularly the new Chancellor’s first budget in the autumn, to understand potential implications for taxes such as capital gains tax, inheritance tax, and pensions tax, as well as any other significant actions. These announcements could impact growth, inflation, and interest rates.

Inflation and Interest Rates

Although Labour appears to be pro-growth, there are concerns that heavy government spending could lead to spikes in inflation, undoing the progress the Bank of England has made in bringing inflation down to its 2% target.

If investors believe that Labour’s policies will result in increased government spending, they may fear rising inflation. This concern could prompt the Bank of England to keep interest rates steady for longer, potentially supporting the pound in the short term.

In summary, while the pound’s rise post-election signals some initial optimism, mixed reactions across other asset classes reflect a cautious market awaiting further clarity. The future direction of the pound will largely depend on Labour’s concrete actions and their impact on growth and inflation. The market is waiting to see the actual measures being implemented before making significant moves.