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Is It Time for the UK to Peg the Pound?

Since the beginning of the year, the pound is down around 7 percent against the dollar. But many can be quick to forget how aggressively the dollar was sold last year.

There are two main themes currently dominating the currency markets. One is the issue of government debt and the other is the potential of a hung parliament after the next UK general election.

While it definitely is too early to refer to the pound as plummeting, it is not too early to start thinking about the unwanted effects of the pound's volatility, according to Steven Gallo, head of market analysis from Schneider Foreign Exchange.

If a currency creates more shocks for the economy rather than helping it rebalance, it means Britain probably would be better off with a fixed currency instead of a floating one, Gallo said.

Britain has the highest level of inflation in the industrialized world, and a large part of this is due to the drop in sterling. If the Bank of England is up against weak growth and high inflation, the market may sell the pound on the idea that the Bank of England's flexibility is removed and it will not be able to support the bond market or hike rates.

The issue of whether the UK will adopt the euro will come up again either around the time of the general election or right after, Gallo said.

Finding Excuses to Sell

Traders will take the possibility of a hung parliament as an excuse to sell the pound, according to Asraf Laidi, chief strategist from CMC Markets.

The reality of the markets is different, though, with focus still being on whether we will see a double-dip scenario, Laidi added.

In addition, the Bank of England is going to be forced to step in and help stabilize the fiscal situation as it isn't unlikely to imagine a debt to gross domestic product (GDP) ratio of 75 percent to 80 percent of GDP in the UK, he said.

Unlike the case of Greece, where currency devaluation is out of the question, the Bank of England increasingly has been resorting to talking down the pound as it benefits the squeezed British exporters, Laidi added.

Currently, when comparing the main central banks in the west, the Bank of England is the closest to injecting fresh liquidity into the system. The Federal Reserve, the Australians and the Canadians are either withdrawing liquidity or thinking about it.

And while the European Central Bank is not injecting any more liquidity, it doesn't seem to be in a rush to exit either as its hands are tied due to debt woes of European countries.