Sterling hit a seven-year high against the euro on Tuesday as traders bet on a divergent monetary policy path between the euro zone, where a €1.1 trillion asset purchase programme began this week, and Britain.
Less than two months before the most uncertain UK parliamentary elections in decades, the cost of hedging against sharp swings in the pound rose sharply.
While the European Central Bank has started flooding the euro zone with money to boost inflation, Bank of England governor Mark Carney said on Tuesday that it would be "extremely foolish" to use more monetary stimulus to fight a temporary plunge in UK inflation caused by declining oil prices.
The Bank of England has previously said it expects its next policy move to be a hike in interest rates from their current historic lows, which investors are betting will come early next year.
The euro fell below 71 pence for the first time since December 2007 to trade at 70.95 pence, down 1 per cent on the day.
Against the dollar, sterling slipped 0.3 per cent to $1.5087 . The greenback has rallied strongly since a stronger-than-expected US payrolls report on Friday that bolstered bets of a Federal Reserve rate hike this year.
"Our view is that the first (British) interest rate rise will not be until the first quarter of 2016," said Adam Myers, European head of FX strategy at Credit Agricole.
“(That) should be sterling negative, but the problem is that the sterling negative at the moment being engineered by the BoE is less than the negative being applied to the euro zone,” he added. Yields on bonds of nearly all euro zone countries hit record lows on Tuesday.
Gilt yield
With little in the way of domestic economic data, British government yields were dragged in the same direction as their euro zone equivalents. The 10-year gilt yield fell by almost 14 basis points to 1.80 per cent, the biggest decline since October 15th last.
Options market pricing showed a jump in the cost of hedging against volatility around the May 7th election date and the weeks after, with the two-month sterling/dollar implied volatility rising to 10.475 per cent, its highest since early 2012.
The three-month implied volatility also rose to a high of 10.25 percent, indicating the uncertainty from the election is likely to spill over into June.
"The two- and the three-month implied volatilities now capture the election date so we are seeing demand," said Peter Kinsella, currency strategist at Commerzbank.
Mr Kinsella said he also expected demand for the longer-dated options, because of the risk posed by a vote on EU membership which the Conservative party has promised to hold by 2017 if it is returned to power.
Reuters
