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(The opinions expressed here are those of the author, a columnist for Reuters.)
By Jamie McGeever
LONDON, June 9 (Reuters) - With growth slowing and the formal start of Brexit negotiations only days away, the political uncertainty blown open by Britain's inconclusive election could not have come at a worse time for sterling.
The greater chance a hung parliament will ultimately lead to a softer Brexit could bolster the British economy and currency in the long run, but in the near term investors should expect a higher degree of volatility in the pound.
First, however, a bit of context. The second biggest British political miscalculation in living memory will have much less of a market impact than the first.
Last year's Brexit referendum triggered the pound's biggest fall since the era of free-floating exchange rates was introduced over 40 years ago. Sterling plunged 10 percent plunge against the dollar.
Implied volatility hit record levels, even higher than in the 2008 global financial crisis, forcing Bank of England governor Mark Carney to come out and calm markets. A few weeks later, the BoE responded to growing fears over the economy by resuming quantitative easing and slashing interest rates to a new low of 0.25 percent.
Currency market moves on Friday so far pale against that. The pound has lost around 2 percent of its value, and one-month sterling/dollar volatility has risen to its highest only since January. Carney isn't expected to address the nation.
But investors are building a higher risk premium into sterling. The difference between one-month implied sterling/dollar and euro/dollar volatility rose to 3.75 vol, its highest since October.
Historically, implied sterling volatility has been lower than euro volatility. Barring a few brief spikes, sterling/dollar vol has consistently been lower than euro/dollar vol since the single currency's launch in 1999. The exceptions were 2008-10 and much of the time since last year's Brexit referendum.
Even still, as recently as April, sterling/dollar vol relative to euro/dollar vol was the lowest since 2015 before snapping back as soon as Prime Minister Theresa May called the election. It's likely to remain elevated as economic and political uncertainty rise.
This trend has been even more stark regarding euro/sterling and euro/dollar. Since 1999 euro/sterling vol has almost always been below euro/dollar vol. Again, the exception was June last year, and in recent weeks the gap has notably widened out again.
"Sterling volatility is the winner," said Jordan Rochester at Nomura.
There's little to suggest those volatility premia will come down. According to the Organisation for Economic Co-operation and Development's global outlook this week, British economic growth will slow to 1 percent next year. That will be the lowest of all 32 countries in the report bar one, sclerotic Italy.
What's more, Britain will be the only one of those 32 countries to post slowing growth four years in a row from 2014 to 2018. Many economists say the election chaos could jeopardize business investment and consumer spending, putting risks to the economic outlook firmly to the downside.
The political backdrop could, on the margins, make it even harder to convince overseas investors that they should keep on plugging the yawning UK current account deficit. Having one of the developed world's biggest current account deficits means Britain relies on "the kindness of strangers", in the words of BoE governor Mark Carney, to balance its books.
Last year the deficit was 4.4 percent of gross domestic product, meaning Britain needed about $100 billion from abroad. There are signs that inflows from abroad may be slowing.
The gloomy economic forecasts were already moulded on the uncertainty surrounding Brexit. From a political perspective, that uncertainty is now morphing into chaos.
May's plea for a "strong and stable" government to guide the country through Brexit was rejected by the electorate. She has said she will not resign but the disastrous result has gravely wounded her, and it must be only a matter of time before she is replaced. But by who? A hard or soft Brexiteer? And will it make any difference anyway?
Because her ruling Conservatives have no overall majority, there's a good chance another general election later this year will have to be held, potentially solidifying the growing political risk premium into the currency.
This is the backdrop to the Brexit negotiations with the European Union that formally begin on June 19. Whichever way sterling goes - analysts say a fall towards $1.20 looks increasingly likely, while hopes of a softer Brexit would push it back above $1.30 - it's going to be a rocky ride.
Reporting by Jamie McGeever; Editing by Toby Chopra