Pound Sterling: "Unavoidable" Snap General Election Poses Downside Risks vs. Euro and U.S. Dollar

Corbyn in talks with May

Above: Labour Party leader ahead of talks with Prime Minister Theresa May. Image (C) Pound Sterling Live.

The British Pound is consolidating against the Euro and U.S. Dollar at the start of the new week, this cautious behaviour should come as no surprise as markets are expecting a potentially explosive few days in British politics.

The consolidation of the Pound-to-Euro exchange rate around 1.1629 looks akin to the market behaving like a coiling spring, readying for a sizeable move in either direction.

The Pound-to-Dollar exchange rate is meanwhile quoted at 1.3053, nearer towards the bottom end of its March-April range.

The key drivers for Sterling in the immediate term are 1) the ability of Labour and the Conservatives to strike a cross-party Brexit consensus and 2) the shape of any Brexit delay offered by the EU to the UK, which both lead to 3) growing fears for a snap general election.

Foreign exchange strategists are increasingly warning their clients that the risk of a snap general election in the UK are elevated and growing, with one analyst saying he sees such an outcome at a 100% probability.

We believe a snap election bodes negative for the Pound Sterling outlook.

Martin Enlund, a strategist with Nordea Markets, says Prime Minister Theresa May "is doomed" and it is very hard for him to see any progress being made on Brexit without a shakeup of the current parliamentary mandates.

"New elections are eventually unavoidable,” says Enlund. "Our view from then is basically 100% intact."

The call comes as foreign exchange markets await a potential agreement between the Labour and Conservative parties on a Brexit compromise that would allow a deal to finally pass through the House of Commons.

While compromise is argued to be a logical step towards seeking resolution to the Brexit stalemate, it comes with considerable risks to both parties as we understand there is entrenched opposition to the talks from both within Labour and Conservative ranks.

Citigroup - the world's largest foreign exchange dealer - today say they are now expecting a snap election over coming months while they expect a long Brexit extension to be offered to the UK by the EU.

If the Conservative and Labour parties are able to strike a compromise we would expect this to be a good week for the British Pound which would likely rally as a the threat of a 'no deal' Brexit is finally put to bed permanently.

"We continue to see substantial upside for GBP on a 'soft' Brexit resolution, but investors may be reluctant to engage while uncertainty remains high and with the threat of general elections looming. Watch for more definitive steps towards a compromise ahead of the EU Council meeting," says Zach Pandl, a foreign exchange strategist with Goldman Sachs in New York.

Conversely, the risk of a cross-party Brexit deal not being struck would present a major risk to Sterling as it leaves UK politics at an impasse with a mere few days before the UK is officially due to leave the EU.

EU leaders due to meet to discuss the issue of a Brexit extension at a special summit on Wednesday have long said they would only grant an extension should there be reasonable grounds to grant one: in short, asking for more time to simply pass the deal under existing mandates might not be held to be reason enough to grant an extension.

Indeed, reports suggest France, Belgium and Spain are strongly opposed to offering an extension unless there has been no material change in the UK's position on Brexit.

It is understood that an extension would be granted were the UK to go back to the public, either in a second EU referendum or general election.

"A longer delay would require the UK to participate in the EU Parliament elections scheduled for May 23-26 but Brussels would need clarity if more time will be needed for a second referendum or new elections for a Brexit rethink. These are hard questions that the UK needs to answer by the EU Summit on April 10. Until then, the legal default remains for the UK to exit the EU without a deal, which in turn, keeps open the risk for the Pound to fall," says Philip Wee, a foreign exchange strategist with DBS Bank in Singapore.

With both major parties appearing to be opposed to a second EU referendum, it stands the most likely vote that would take place would be a general election.

For Sterling, a general election is seen to be a significant downside risk as it ushers in a period of political uncertainty in the UK.

Currencies tend to show a negative reaction to bouts of political uncertainty, with the Pound's performance over recent years in response to general elections and the EU referendum bearing testament to this.

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The impact of political uncertainty on the UK economy is most clearly seen in the impact placed on business investment. Data for the fourth quarter suggests business investment fell by 0.9% quarter-on-quarter.

"This was the fourth consecutive quarter-on-quarter fall in business investment and the first time that this has happened since the economic downturn of 2008 to 2009," says Jane Foley, an analyst with Rabobank in London. "It is rare to see such consistent pressure on business investment outside a recession."

Rabobank image business investment

Image courtesy Rabobank

"UK economy still faces headwinds from uncertainty, business investment has slumped while employment growth remains solid," say Citigroup in a research note dated April 08.

Of particular concern to markets facing a general election is the prospect of Jeremy Corbyn's Labour Party winning: Corbyn is a devout leftist who promises to usher in a raft of socialist-inspired economic policies.

"While polls suggest that the Tories could still be the biggest party after an election, they may not win sufficient seats to form a government even with the support of the DUP. This would allow the Labour Party a chance to take the reins potentially with the backing of three or four smaller parties. In view of Labour’s plans to renationalise several UK companies, GBP investors could take fright at the idea of a government led by the far-left’s Corbyn," says Foley.

On the assumption that a Brexit deal can be found, Rabobank are forecasting that the Pound-to-Euro exchange rate can trade around 1.22 on a 6 month view.

"Given the increasing risk that political clouds will continue to loom over the UK economy for some time, we are beginning to worry that this GBP forecast could be too optimistic," says Foley.

Latest polling data does not look good for the incumbent Conservative party which has apparently lost substantial ground in the event of Prime Minister Theresa May's recent pivot towards a "softer' Brexit having failed to unite her party around the deal she has struck with the EU.

According to Poll of Polls data, the party is now at 35% against Labour's 34%; as recently as February the Conservatives were seen at levels around 40% against Labour's 33%.

Poll of polls

"We turned Negative GBP recently due to markets not pricing the risk of a Corbyn government adequately in our view," says Thanos Papasavvas, Founder & CIO of ABP Invest. "The population is getting fed up with the Tories' constant internal crises and their inability to form policy."

Odds at Betfair - the betting exchange - for a 2019 election currently sit at a non-neglible 7/4.

BannerTime to move your money? Get 3-5% more currency than your bank would offer by using the services of foreign exchange specialists at RationalFX. A specialist broker can deliver you an exchange rate closer to the real market rate, thereby saving you substantial quantities of currency. Find out more here.

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