UK vote shock may boost long-term pound on soft Brexit

London - A poor result for Prime Minister Theresa May in Thursday’s UK election may be good for the pound further down the line.

Although sterling could fall in the immediate aftermath of a weaker majority for May’s Conservative Party or a hung parliament, it could also increase the prospect of a so-called soft Brexit - one with continued access to Europe’s single market or a transition period. That could give traders a reason to be bullish once the election dust settles, say strategists from Morgan Stanley, Nomura International and Bank of America Merrill Lynch.

"There is that fundamental difference between potential short term and longer run reactions,” said Andrew Sheets, chief cross-asset strategist at Morgan Stanley. A narrower-than-expected Conservative majority "increases the odds of a softer Brexit, which would be more consistent with the pound trading up into the 1.30 to 1.40 range," he said.

That would mark a step up for sterling, which has mostly been hovering below $1.30 since May called her snap election in April. The currency has whipsawed in the face of changing opinion polls that have shown the Conservative Party’s lead narrow from 20 percentage points to between one and 12 points.

A smaller majority could mean May would have to pursue a hard Brexit to get enough support from euro skeptics in her own party, or damp some of her stance in order to get the final deal accepted by parliament.

Pro-Europe coalition

The narrowing polls have also rendered a hung parliament a possibility, where no party has an overall majority.

In that scenario the Labour Party may have the best chance of forming a coalition. Even though leader Jeremy Corbyn has said they would not seek to overturn the Brexit referendum result, single market access remains a priority. Also, any potential coalition would likely be formed alongside the pro-European Liberal Democrats or Scottish National Party.

While "the market would be focused on economic implications from higher taxes and what that would mean for growth, the softer Brexit angle may be a market force to watch out for," said Jordan Rochester, a foreign-exchange strategist at Nomura International. Sterling may rally "but it could take a few days or so if a coalition takes time to form."

Bank of America Merrill Lynch analysts also said that a Labour-led coalition would be the "sweet spot" for sterling. A Conservative victory would initially be bullish, but no guarantee of future performance.

"Fiscal stimulus, including a lifting of the public sector pay cap and infrastructure spending are short-term growth and inflation positives, while the increased likelihood of a soft Brexit - perhaps a Norway type deal - and a rekindled chance of a second EU referendum would support that sense of a growth revival," strategists led by Kamal Sharma said in a note to clients.

Playing chicken

That said, it might not be long before traders forget about the election altogether, turning their attention instead to Brexit negotiations, which start just 11 days after the vote. For John Hardy, head of foreign-exchange strategy at Saxo Bank, talks will take two years plus potentially 10 years of transition before the UK finally leaves the bloc.

Whoever is in charge, it may not change the equation if the EU insists on a hard approach and persists with a large Brexit bill stance, he said in emailed comments.

The pound is already "heavily discounted, but could get weaker if the EU wants to try the 'maximum pain' negotiating stance as an opening move and there is a game of chicken."