David Prosser: It could be a volatile week on the markets – but just sit tight

City analysts last night warned investors to prepare for a volatile week on the financial markets amid political uncertainty and nervousness about the debt crisis that has rocked the eurozone for several weeks.

The City is braced for falls on the stock, bond and currency markets this morning, with a clear picture yet to emerge of the shape of the next government and how, crucially, it might get to grips with the UK's record deficit.

The currency market is the most vulnerable to political anxiety, with a further sell-off of sterling almost certain today. Investors marked down the value of the pound by about 3 cents against the dollar on Friday, with sterling even falling against the euro, despite the turmoil in the single currency zone.

A further depreciation is likely this morning, particularly against the dollar, which will benefit from a "flight to quality" as investors flee the turmoil on European markets.

On the bond markets, the yield on gilts – the effective rate of interest that Britain has to pay in order to service its debt – rose slightly on Friday and may move slightly higher still.

However, despite the £178bn borrowing requirement this year, the UK is in a relatively fortunate position, with its debt due for refinancing over longer periods than any of its European neighbours. Investors in gilts have so far largely taken Britain's political uncertainties in their stride.

Although the market has been pricing in the possibility of a hung parliament for months, the eurozone crisis has underlined the fragility of the public finances in most European nations and increased pressure on Britain's politicians to rapidly agree a deal.

Still, analysts believe the politicians have time to agree on the shape of the new government before investors move into full-blown panic. Both Standard & Poor's and Moody's, two of the three credit ratings agencies that rank the UK's creditworthiness as AAA, the highest standard possible, said that the hung parliament did not in itself make a downgrade any more likely.

However, extended uncertainty would be more dangerous, especially with market confidence so fragile for other reasons. In 1974, the last time Britain had a hung parliament, share prices almost halved in the eight months before Labour won a decisive victory in the second ballot of the year.

In the very short term, the detail of the latest rescue package agreed for Greece and other indebted European nations last night by the EU is likely to be more influential in the markets than Britain's political situation.

If the EU's finance ministers are unable to show over the next few days that their action plan is up to the job of preventing the debt crisis spreading, the deterioration of the markets would become much more serious.