GBP: Greater two-way risks on UK election surprise - ING

In view of analysts at ING, the tightening of polls over the past two weeks – and uncertainty over the size of the potential Conservative majority – means that from a market perspective, this week's UK election has just got a lot more interesting.

Key Quotes

“With no discernible signs of GBP trading at a short-term premium or discount - and positioning a lot cleaner after the recent short squeeze - there are now serious two-way risks to the pound in the event of an election surprise.”

“GBP: A GE2017 scenario analysis approach

We still think there are three scenarios to consider: (1) a landslide victory for PM May; (2) a narrow Conservative win; and (3) the tail risk of a hung parliament. The real focus for GBP in the initial aftermath will be on the extremes - either a sizable (+100) Conservative majority or the uncertainty of a hung parliament would be a relative surprise at this stage and could see a meaningful move higher or lower in GBP.”

“Phase 1: GBP’s knee-jerk reaction is a function of securing political stability

Political clarity is GBP supportive, but we’ll need to see a Tory majority of at least 50 to get a significant move higher. GBP’s initial knee-jerk reaction is now a question of whether we can get a stable political environment. Contrary to our prior belief, the status quo of a Conservative majority – and a small gain in seats – should be supportive for the pound. Indeed, the last-minute tightening of polls means that this elections now draws greater parallels to the 2015 UK General Election – as well as the recent Presidential Elections in the US and France. In all three cases, the currency reacted positively as the event risk passed and political uncertainty faded. However, to get a meaningful move higher in the pound, we still think that Mrs. May will need to extend her majority to at least 50 – and realistically a lot closer to a 100. This could take sterling up to 1.32 against the dollar.

It’s not that simple anymore… the real downside risk – and the worst case for sterling come Friday morning – is a hung parliament. Maximum chaos would be if the Conservatives were only able to get somewhere between 290 to 325 seats; it’s the grey area where it’s not enough for a Conservative majority, but also potentially not enough to see a stable Labour-led coalition being formed quickly. Uncertainty is the pound’s well-known Achilles' Heel and in a hung parliament scenario, we think it could fall to 1.24 against the dollar. Equally, it may be tempting to draw parallels to a Corbyn GBP relief rally and what was observed in the USD after President Trump was elected (where the initial sell-off was quickly reversed). However, we would stipulate that a stable coalition would need to be formed before markets can start making any sweeping assumptions about changes to Brexit policy etc.”

“Phase 2: Brexit policy will once again be the focus for GBP once the dust settles

Looking beyond the election, the focus for GBP will shift back to Brexit. What has always mattered for GBP with respect to this General Election is any nuanced changes to the UK’s Brexit stance – and this is where we could see a moderation of any extreme moves.”

“Conservative majority: GBP bulls may need to progress on orderly Brexit promises

• Under a Conservative majority government, we suspect that we’ll need to see visible progress towards a divorce deal by both sides for the pound to move another leg higher (eg, GBP/USD up towards 1.35 and EUR/GBP down to 0.83). GBP's recovery since April has been underpinned by hopes of an orderly transition deal and beyond the election, investors will most likely want to see tangible evidence of progress before buying into a full-blown GBP recovery.
• There's certainly a question mark over how soon after the election this could happen and that may limit any positive GBP momentum in the near-term. It's worth also keeping an eye on PM May's Cabinet reshuffle - likely within a few days of the election - for subtle hints over future Brexit policy (though we wouldn't make any stretched assumptions here).”

“Labour-led coalition: GBP to balance greater likelihood of a softer Brexit versus Labour policy concerns

• If a credible Labour-led coalition can be formed quickly, then we are likely to see markets price in greater odds of a softer Brexit deal and this could arguably help GBP recover from any initial sell-off. From the currency's perspective, this channel is likely to outweigh any questions over Labour’s economic policies.
• That said, there will be plenty of parallels to be drawn between Corbyn’s manifesto and the Labour party of the 1970s – including much greater influence of trade unions, the re-nationalisation of core industries such as the rail network and question marks over revenue assumptions to fund aggressive spending plans. Investors will be reminded of the UK’s US$4bn emergency loan from the IMF in 1976, after the left wing of the ruling Labour party rejected austerity to address 10% budget deficits. GBP trading like an EM currency, enjoying a negative correlation with gilt yields as it did briefly in October 2016, would be the outside risk.”