UK GE 2017: Pound hung out to dry - ING

The failure to secure political stability and the outcome of a hung parliament is going to be the pound’s nightmare scenario suggests Viraj Patel, Foreign Exchange Strategist at ING.

Key Quotes

“With the two-year Article 50 clock ticking, the passage of time is GBP negative; a working government is needed as soon as possible to avoid a further drop in the pound. The worst outcome for GBP now is any prolonged political uncertainty and difficulties in forming a working government over the coming days; here we would expect the pound to trade with a 3-4% political risk premium, which would see GBP/USD fall back to 1.24 and EUR/GBP move up towards 0.90.”

“Still, as the sequence of events after the 2010 election showed, the formation of a coalition government is no guarantee that we will see the pound stabilise over the coming weeks. The focus will quickly shift to scrutinising the Brexit policy of the new government and it is looks all the more likely that a Conservative-led coalition will be compelled to retain a hard-line Brexit strategy. With GBP already cheap and trading with a sizable ‘hard’ Brexit premium, this shouldn’t alter the currency’s longer-term fundamentals. Visible steps towards a transition deal hold the key to unlocking gains in GBP and domestic political delays means that this looks less likely to be achieved anytime soon.”

“One thing’s for sure, GBP hates uncertainty…

• GBP’s nightmare scenario. The failure to secure political stability – and the outcome of a hung parliament – was always going to be the pound’s nightmare scenario. Markets were going into these elections on the presumption that political uncertainty would decrease substantially under a more stable Conservative government. That narrative has been all but dashed.
• The passage of time is GBP negative, a working government is needed asap to avoid a further drop in the pound. With the two-year Article 50 clock ticking and a strong need for Brexit negotiations to start as soon as possible in order to avoid the growing risks of a cliff-edge, GBP’s best hope from here is that some form of working government can be drawn up quickly. The most likely path looks to be a Conservative-led coalition with the Democratic Unionist Party (DUP) – which would give the narrowest of overall majorities in parliament. However, it might not be quite as straightforward given the noise surrounding Theresa May possibly stepping down as leader; a beleaguered GBP won’t react favourably to a Conservative leadership contest at this point.
• And if the Conservatives can’t form a coalition… Jeremy Corbyn’s only realistic chance of becoming PM is by forming a minority Labour government – although this looks logistically improbable. The SNP and Liberal Democrats had ruled out a formal coalition prior to the elections; even if they changed their mind, their combined number of seats wouldn’t be enough to have an overall majority in parliament. Given the low likelihood of PM Corbyn – markets at this stage are unlikely to entertain prospects of a softer Brexit or Labour’s more contentious economic policies.”

“So what does a hung parliament mean for Brexit policy and GBP fundamentals?

• Formation of a Conservative-led coalition could see a small GBP relief rally, but the focus will quickly shift to Brexit policy. As the sequence of events after the 2010 election showed, the formation of a coalition government is no guarantee that we will see the pound stabilise over the coming weeks. The focus will quickly shift to scrutinising the Brexit policy of the new government and there is now a greater risk that a Conservative-led coalition will be compelled to retain a hard-line Brexit strategy. Indeed, our economists note that the DUP are pro-Brexit – sharing similar values with Theresa May’s ‘Clean Brexit’ vision (which in effect is synonymous with a ‘hard’ Brexit).
• GBP’s ‘hard’ Brexit premium likely to remain in place until we see visible steps toward a transition deal. A Conservative-DUP coalition means that very little is likely to change from a fundamental perspective and we do not expect to see any wholesale changes to the current Brexit assumptions being priced into markets. In our view, visible steps towards a transition deal holds the key to unlocking gains in GBP and we note that the UK general election was never a guarantee that a transition deal would be signed, sealed and delivered. It was merely an assumption that markets were making based on logistical factors – namely that there are now five years for the UK to tackle Brexit before another domestic election is held. Still, we reiterate that it does take two to tango – and we need to see whether the EU will be willing to offer a cost-free and painless transition. The bottom line – none of this looks likely to be resolved anytime soon, which reduces any immediate GBP upside risks.
• Could Theresa May move to the ‘Brexit centre ground’ given the Conservative’s loss of seats? Our economists note that this cannot be ruled out, though this remains a distant factor for markets to consider at this stage. Odds of a more conciliatory Brexit tone from the Prime Minister remain low, but investors will no doubt be watching out for any subtle signals from the new government over Brexit policy.”