LONDON (Reuters) - The Liberal Democrats have leapt in opinion polls after an impressive performance by their leader Nick Clegg in a TV debate with Labour Prime Minister Gordon Brown and Conservative leader David Cameron.
The surge in popularity for the Liberal Democrats has made an inconclusive result after the May 6 election appear more likely.
Below is a look at a few of the scenarios that could play out next:
Prospects: Quite likely.
This is probably the most favoured outcome for investors who prefer the Conservatives’ harder deficit reduction approach.
Liberal Democrat leader Clegg still has to face two televised debates with Brown and Cameron on the economy and foreign affairs -- areas where his promises of a fresh approach may not be so convincing. The first debate was on social issues.
While many voters are tired of the status quo, the worst recession since World War Two has done wonders to focus minds on policies and Clegg could struggle to hold his own. Viewers had no expectations, and little knowledge, of the Liberal Democrat leader last week. Expectations may now be too high.
In their favour, the Liberal Democrats are seen as the least tainted by last year’s expenses scandal.
Voter apathy has been on the rise in recent elections. The expenses disclosures have turned that into widespread anger.
But the Liberal Democrats have a fight on their hands to hold on to some of their own parliamentary seats, particularly from Conservative candidates.
The LibDems’ sudden surge in the opinion polls could just as quickly lose momentum, leaving the party as a relatively small, but crucial, player in a coalition government.
After initial uncertainty on markets as the parties haggle over a deal, expect a relief rally in sterling once agreement is reached. Bond yields could fall in a similar fashion although both reactions are likely to be short lived.
Prospects: Quite likely.
It would be a brave investor who bets against the Clegg bounce fading a little.
The Liberal Democrats do not have the army of union activists that Labour can call on to knock on doors and rally voters.
Nor does the centrist party have the large financial resources or the number of local government councillors at the disposal of the Conservatives, the pre-election race favourites.
Even if Clegg holds his own in the forthcoming foreign policy and economy debates, winning much more than 100 out of 650 seats seems unlikely. The party currently has 63 MPs.
Using crude prediction models, Labour appears to be the biggest benefactor from a larger Liberal Democrat vote, putting Brown in the driving seat after the election on May 7.
A bigger Liberal Democrat presence in parliament would mean the party would want a bigger say in coalition policies and that could spell trouble for Labour because the smaller party is unimpressed with Brown’s deficit reduction plans.
The Liberal Democrats have said they would be the budget deficit guarantors for markets in the event of a hung parliament, where no one party has overall control, so investors may feel more comfortable with the prospect of a Labour-led government
Nonetheless, this outcome would probably see a fall in sterling and rise in gilt yields during any coalition haggling. Markets would also be on the back foot once a deal was in place because investors have already expressed concern that Labour’s deficit reduction plans are not explicit enough.
Prospects: Fairly unlikely.
A Conservative or Labour minority government is hard to envisage but not beyond the realms of probability.
However, any such outcome would be taken badly on markets with sterling falling and gilt yields rallying because of the uncertainties it would throw up over Britain’s economic policies.
While not unworkable, the Liberal Democrats are aware of the consequences that could await British borrowing costs if there is any delay in executing deficit reduction plans and would therefore probably favour forming a coalition rather than refusing one.
Prospects: Highly unlikely.
It is worth remembering that under Britain’s electoral system, the Liberal Democrats only won about 10 percent of seats despite securing 20 percent of the popular vote in the 2005 election.
Because the system is biased towards the two big parties that command loyalty across the country, the Liberal Democrats will need a very large swing on top of that already seen this week to stand any chance of becoming the largest party in parliament.
Financial markets would react most violently if this scenario played out with sterling falling sharply initially and government bond yields rising.
Investors are largely unaware of Liberal Democrat economic policies. That, combined with uncertainty over how the party would agree terms with any coalition partner, would probably rattle markets.
Ordinary members of the party would probably prefer a Liberal Democrat/Labour coalition but if Labour wins fewer seats than the Conservatives, Clegg would be obliged to bring Cameron in to government.