FxWirePro: How does UK politics transpire soft or hard Brexit and its impact on sterling?

Given the general election surprise, it is noteworthy that the market has taken the news of a Conservative minority government (propped up by the DUP) within its stride.

After falling to 1.2710 on the election results, cable is now traded lower to 1.2636, before consolidating for the rest of Friday. To a degree, this was in line with pre-election option market expectations.

Well, Sterling now seems to be cheaper relative to the dollar on the basis of purchasing power parity, albeit for very good reason. However, it isn’t noticeably cheap relative to the EUR or any of its other satellite currencies (the SEK, PLN, and HUF stand out).

Brexit negotiations will add to policy uncertainty, shackle the MPC and drag EUR/GBP into the 0.90-0.95 range.

When assessing the potential reaction of GBP to the election outcome, we first need to understand what caused GBP to rally when the election was announced, and how the market’s perception of the political calculus may have changed since then, particularly as it pertains to Brexit. The enthusiasm with which GBP initially greeted the election was predicated on two assumptions.

The first of these was reasonable – delaying the subsequent general election from 2020 to 2022 could provide the next government with breathing space to consider transitional arrangements for exiting the EU in order to prevent the economy falling off a Brexit cliff when the UK leaves in 2019 (the tail risk from Brexit is reduced).

The second assumption was more questionable in our opinion – that a substantially enhanced parliamentary majority would enable May to pursue a softer Brexit as she would no longer be in thrall to her eurosceptic backbenchers.

The latter assumption presupposes that the PM herself favors a softer Brexit which prioritizes trade over sovereignty. But in our opinion, there is little to substantiate such a notion, certainly not the Conservatives election manifesto which conspicuously retained a pledge to reduce migration to the tens of thousands and reiterated that the UK would exit both the single market and the customs union.

In our judgement the election will not affect the modal outcome for Brexit or GBP assuming that the Conservatives win– Brexit is still likely to feel rather hard insofar as it is liable to circumscribe the UK’s single market access, even if the change in the electoral timetable should temper the tail risk of an outright disorderly Brexit in 2019.  Having initially entertained hopes that a larger Conservative majority would be positive for GBP, the subsequent reversal in GBP suggests that investors have moved closer towards our position that May will pursue a relative hard Brexit irrespective of the size of her parliamentary majority.