Another volatile political event for Sterling
Sterling looks set for yet another night of politically driven volatility as the UK essentially chooses between a massive Tory led fiscal expansion, and an even more massive Labour led fiscal expansion.
Although government spending will be strongly accommodative in any of the plausible configurations for the next government, the similarities between Labour and the Conservatives end there.
A Tory majority is likely to be positive for sterling in the short run. No deal risk would be greatly diminished, and there would be no prospect of policies as risky as Labour’s proposed state appropriation, for example.
Although a Conservative majority is a comfortable base case at the moment, after the shock poll results of the original referendum and the US Presidential election, we believe it is far from fully priced in.
Confirmation of a Tory majority is still likely to see some upside for sterling, although we believe it’s likely to be limited, and in the order of roughly 2%.
There are several very important caveats to the idea that a Tory win will be meaningfully positive in the medium term for sterling. Given the implausibly tight timeframe Johnson has set himself to strike a free trade deal with the EU, it’s highly likely that either an extension or huge UK concessions will be necessary. A narrow Conservative majority may mean he is constrained in his ability to do either – and so blunt any sterling rally. Even with a solid majority, ongoing uncertainty about future trade relations with the EU may continue to hamper business investment.
Markets bracing for hit to Sterling in event of hung Parliament
A number of aspects of Labour’s hard-left manifesto mean that markets appear to be treating a Corbyn-led Government as a substantial downside risk for sterling. Among the most noteworthy are a massive programme of nationalisations, and outright state appropriation of large company equity, set amid a backdrop of huge deficit spending.
Our view is that sterling would weaken in the order of 6% in the event of a hung parliament and a likely Labour led government.
However, with powerful coalition partners restraining the riskier ideas in the Labour manifesto, a healthy whack of fiscal spending, and a second referendum, it’s possible sterling’s losses will be relatively short lived in this scenario.
Elections are not great guides to future sterling trends
Care should be taken in assuming sterling’s reaction on the day of the election will be a guide to price action over the coming weeks and months. As always, hype and human behaviour in a market context mean markets may overshoot the fundamental significance of the event itself.
As a result, the market reaction to an election is often a poor guide to future trends. For example out of the seven elections since 1992, the 2005 vote was the only one where GBPUSD did not trade through its value before the election at some point in the following 3 months.
Uncertainty over the UK’s future relationship with the EU may persist for some time. Judging the size of any post Brexit recovery in UK growth is difficult and will take time as the noise in economic data from stockpiling and global uncertainty subsides.
As a result, although we are optimistic about sterling’s prospects through to the end of 2020, caution should be taken in relying on a persistent rally in the immediate aftermath of the election.
The key factors for sterling will be the response of domestic business investment to the electoral outcome, and the future outlook for both global and EU trading relationships.
Options markets are treating the election as a volatility event comparable to this year’s two Brexit deadlines
One week GBPUSD volatility at highest since the October deadline, while 25D 1M risk reversals are the most negative since the March deadline
GBPUSD 3 months following UK elections
Author: Ranko Berich, Head of Market Analysis at Monex Europe.