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Pound Surge Suggests U.K. Election Will Yield Smoother Brexit

by Pan Pylas
Friday Apr 21, 2017

The British pound's surge since Prime Minister Theresa May's surprise call for an early election is an early sign of confidence that the country's exit from the European Union will be smoother than many had feared.

While the vote increases uncertainty in the short term, traders think that the expected resounding victory by May's Conservative Party could help the prime minister face down critics - both within her ranks and the opposition - in her Brexit discussions.

Spiking by more than 3 cents to $1.2876 in the hours after May's announcement Tuesday of a June 8 general election, the pound is now at its highest level since early October.

Based on this initial reaction, investors appears confident that May will end up with a bigger majority in Parliament that will give her a stronger position in the Brexit negotiations with the other 27 EU states.

Some opinion polls have the Conservative Party a whopping 20 percentage points ahead of the main opposition Labour Party. That sort of victory could deliver May a majority of more than a 100 in the House of Commons, compared with just 17 now.

Though May has been cautious in detailing her Brexit strategy, traders think a big victory for in the election could give her ammunition in dealing with those within her own Conservative Party who are urging a complete, "hard" divorce from the EU - even if that means new tariffs and an exclusion from the bloc's huge single market.

"We see this decision as much as a decision to curtail the 'hard Brexit' faction within the Conservative Party as it is to contain anti-Brexit political parties," said Derek Halpenny, European Head of Global Markets Research at Bank of Tokyo-Mitsubishi UFJ.

It's this prospect of a so-called "hard Brexit" that has mainly worried businesses in Britain, many of which trade intensely with the EU, the biggest destination for British exports.

The fear of that economic damage has been reflected mainly in the pound's weakness since the initial shock of the Brexit result last June, which saw the currency tank from the $1.50 mark to 32-year lows around $1.20. The currency fall does help exporters by making their goods more competitive, but that is a one-off gain that could be more than offset by the impact of EU tariffs on British goods and barriers to trade.

Last month, May formally began the two-year divorce talks with the EU and hopes her government can settle the exit terms alongside talks on what the new relationship with the EU will be. The EU wants to first reach a deal on the exit deal and has insisted that any future relationship must be seen to be inferior to full membership.

Traders also think that a convincing election victory for May will give her greater flexibility in in talks with the EU. There won't be a scheduled British general election until June 2022, eliminating the risk of an election campaign disrupting the Brexit talks.

Deutsche Bank economists said they were changing their view on the pound following May's election call. Describing it as a "game-changer," they say a larger Conservative majority, if it emerges on June 8, makes the "deadline to deliver a 'clean' Brexit without a lengthy transitional arrangement by 2019 far less pressing given that no general election will be due the year after." They also say that a big victory for May will dilute the influence of those lawmakers pushing for a "hard Brexit" as well as strengthening May's overall negotiating stance.

Still, elections have a habit of delivering unexpected outcomes. May will be aware that early elections in Britain have not always gone according to plan.

In the last snap poll, in 1974, then Conservative Prime Minister Edward Heath called an election on the question of "Who governs Britain?" while he was battling striking coal miners. Ultimately, the British people decided it wasn't Heath and Labour's Harold Wilson returned as prime minister.

The fate of May's predecessor, David Cameron, also holds out a potential warning for May. This time last year, Cameron fully expected Britain to vote to remain in the EU in the referendum he had called for June. Instead, the British decided to leave in a vote that has roiled British politics ever since, starting with Cameron's resignation.

"Even though this outcome appears unlikely this time out, it remains a possibility and would represent the second major miscalculation by a PM in as many years," said David Cheetham, chief market analyst at XTB.

As such, few traders are making big calls of a long-term rise in the pound. Some have even said the reaction since May's announcement was overdone and liable to a reverse.

"Even though May looks set to secure a strong mandate from U.K. voters, the priority of EU negotiators heading into the Brexit talks remains the protection of the EU," said Jane Foley, senior foreign exchange strategist at Rabobank. "The Brexit talks are still set to be tough and the result could still deal a blow to the U.K. economy."

Hardly a recipe for long-lasting currency strength then.

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