The British bond markets are resting on two presumptions.  The first is that the Conservatives will get in with a working majority and the second is that the Conservatives will get on and slash the deficit by cutting taxes and raising taxes.  In this way there will not be the flood of new bond issues on to the market that the current government is planning.

We’ve covered before what would happen if the Conservatives lose the general election.  Without repeating ourselves the Conservatives are far more likely to lose the general election than most people in the market think and if they do the pound will go down, the stock market will go down and bond yields will go down.  Going short on all three is still a value proposition even after the last few weeks of turbulence.

However what if the Conservatives do get in and don’t act in the way the market expects?  They could do one of two things, wimp out over public expenditure or look at ways of raising consumption through cutting rather than raising taxes.

The effect on the stock market should be broadly neutral as although there will be more spending and a lower pound, this will be offset by rising real interest rates – that is those rates charged by companies.  However the pound and bonds will tank.  Now look at spread bets and CFDs, are they tanking?  Well no.

So should they be worried?  The Conservatives have become remarkably coy recently about spending cuts.  There won’t be that many, they say.  For the first time in a generation there is popular hunger for spending cuts (at least those that affect other people) and here is the economically sane party backing away from them.  Why?

Well they originally told everyone that there would be sharp cuts so that they had a mandate when they got in.  They still believe (like all politicians in private) that cuts will have to be made after the election and they still want a mandate.  However they realise that they have been too sharp for their own good and the market’s underpinning of Britain’s AAA Bond rating is that the Conservatives will come in.

So what if the Tories manage to spook the market?  Well there will be a pre-election market crisis.  The electorate will look at the sound money party, the Conservatives, and the Tories will have a ready made excuse for four years of cuts.  Expect a lot more softening of Tory rhetoric until that crisis comes.

Will the crisis come before the election?  We don’t know but it sounds like it’s worth a flutter.

Last Updated: February 25th, 2010