Political fallout from budget key for markets

Chancellor of the Exchequer Alistair Darling addresses delegates during the 'Positioning Scotland for economic recovery and growth' conference in Edinburgh, Scotland February 12, 2010.

LONDON (Reuters) - Financial markets will watch the government's budget on Wednesday more for its effect on opinion polls than for its economic measures, given how closely fought a likely May election is shaping up to be.

But there is still plenty of scope for stocks and government bonds to move on the detail of what is announced.

In such a febrile electoral climate, calculating the amount of political capital won or lost on the back of the budget will be more important to investors than establishing its stock specific or macro economic implications.

That sensitivity was reflected when sterling suffered its biggest fall for a year against the dollar on March 1 after a poll indicated the election would result in no one party gaining a clear majority -- a hung parliament.

But while the impact on the political landscape will be the bigger long term consideration, there could be some volatility on the day as investors analyse the specifics of the measures.

Bank stocks could tumble if Chancellor Alistair Darling signals that he will tax the sector.

Pressure on him to do so increased after opposition Conservatives said over the weekend they would introduce a unilateral tax on banks similar to that planned by U.S. President Barack Obama if they win the election, likely to be held in early May.

"It could have an impact if there's a more significant cross party mandate to take action, but the UK government is a very large holder of bank equities, so you have to ask if they want to prejudice any potential sale," said Jonathan Lawlor, head of European research at Macquarie.

The gilt market will be particularly attuned to the deficit forecasts Darling announces after recent public debt figures looked a little less parlous than expected.

Barclays reckons gilt issuance will fall to 170 billion pounds from the 225.1 billion pounds pencilled in for 2009/10 and below the median forecast in a Reuters poll for 187 billion pounds.

"Despite the fall in issuance in fiscal year 2010/11, the market will look for further evidence of greater fiscal tightening," said Simon Hayes, economist at Barclays Capital in a note.

"However, bear in mind that this is the final fiscal event before an election, expectations for greater fiscal rectitude are likely to be disappointed in our view."

ALL EYES ON POLLS

Both main parties are committed to cutting Britain's debt although the Conservatives, who until recently had held sizeable leads in the polls, say they will act faster.

Market concern that a government with a narrow majority or no overall majority at all may not have the clout to push through painful spending cuts is the key factor at a time when ratings agencies are sounding the alarm about record debt.

"If you see another poll (after the budget) with Labour reducing the Conservative lead to 2 percent, that could put pressure on sterling and gilts," Philip Shaw, chief economist at Investec, said.

Two opinion polls on Tuesday indicated Britain was heading towards a hung parliament but differed over whether Labour or the Conservatives would be the largest party.

Any sterling drop may not be of the magnitude seen on March 1 -- when polls pointed up the same scenario -- given the extent of short positions already held by investors.

Net short positions for sterling were at their highest since 1999 earlier in March, according to data from the CFTC.

"Perhaps sterling will not take such a pasting. However, I suspect equities and gilts may be hit rather harder and would not want to be long of either, going into what could well be a volatile week," said Peter Dixon, economist at Commerzbank.

The likelihood that another budget will have to be drawn up after the election -- particularly if the Conservatives win -- also makes the political fallout from this one, rather than its specifics, the broad focus for financial markets.

"The budget will be all about credibility. The public finances figures were better than expected, but another few billion here or there still leaves the UK with a huge hole to fill," said Gavin Friend, currency strategist at nabCapital.

"Sterling could move either way on the budget but it won't change the big picture and it is likely to stay within its recent ranges unless polls show a sustained run of Conservative leads of 9-10 percentage points or more," he said.