Conservative MP Resignations Knock Pound Sterling Off Recent Highs vs. Euro and Dollar, General Election Now More Likely

Above: Anna Soubry, the most high-profile of Conservative party defectors. Image © Gov.uk.

The Government's working majority in the House of Commons has now been reduced to 8 following the resignation of three Conservative party MPs who have opted to join 8 former Labour MPs in the so-called Independent Group, injecting a fresh dose of uncertainty into the Pound's outlook.

Pound Sterling had been on a strong footing heading into late-morning London trade owing to supportive newsflow on the direction of EU-UK Brexit negotiations before three Conservative MPs - Anna Soubry, Heidi Allen and Sarah Wollaston - announced they were resigning the party owing to the government's handling of Brexit.

News of the defections - while not entirely surprising as rumours had been circulating for days - has seen the Pound pare gains as the move increases the prospect of a general election and makes it harder for rebels to vote against the government and delay Brexit. The Pound-to-Euro exchange rate is quoted at 1.1492, having been as high as 1.1518 earlier in the day and the Pound-to-Dollar exchange rate is quoted at 1.3020, having been as high as 1.3079 earlier.

"From GBP’s perspective there are positive and negative side-effects of today’s news that three Conservative MPs have left the Party to join the eight Labour MPs sitting as Independents. On balance, we think the negatives dominate," says Adam Cole, a foreign exchange strategist with RBC Capital Markets.

While the near-term market impact on the resignations is not necessarily a hammer-blow to Sterling, in our view this development increases the downside risks in Sterling's outlook because of two reasons:

1) It lessens the chances of parliamentary rebellion
2) It increases the prospect of a general election

I will deal with each point separately:

On point 1:

Now that rebels in the Conservative party have left, the party is devoid of the notable 'ring leaders' of previous rebellions, particularly in the form of Anna Soubry who was a galvanising force in the pro-EU wing of the party.

Voting with rebels in your own party is one thing, rebelling and coordinating with an opposition party is quite another.

Granted, this could therefore be a good outcome for May, and increases the chance of her deal passing. But, this misses a more immediate parliamentary issue: that of parliament's ability to force a delay to Brexit and avoid a 'no deal' outcome on March 29.

The market has bid Sterling through 2019 on the growing realisation that parliament will be able to vote against the government and force it into adopting a delay to Brexit, with the view to perhaps formulating a softer Brexit.

Our ⁦@Adamstoon1⁩ ⁦@EveningStandard⁩ on splits pic.twitter.com/9PAtr2V6FJ

— George Osborne (@George_Osborne) February 20, 2019

Can this assumption continue to hold now that three key rebels have left the Conservative ranks? We think it has gotten a great deal harder for those wavering on whether or not to vote against the government, and is therefore a negative for Sterling's near-term outlook. If parliament cannot vote to force the government into an extension of Brexit, the opportunity might come as early as February 27, then markets might become a great deal more nervous.

That said, Nick Boles and Dominic Grieve remain Conservative party members, and they have been two crucial figures in formulating previous amendments that resulted in defeats for the government.

If we see these two names defect over coming days then this becomes a scenario we feel markets might take more seriously.

"Insofar as neither the electorate, parliament nor the EU favour a no deal Brexit it is our view (and that of the market consensus) that a deal will eventually be passed. That said, the odds in favour of a hard Brexit have grown as the March 29 deadline approaches," says Jane Foley, a foreign exchange strategist with Rabobank, commenting following news of the defections.

On point 2:

The Prime Minister's Majority in parliament is now down to 8 (or 7, depending on your source), this includes those DUP's backing the government in a confidence and supply agreement.

If she loses 8 more Conservative party MPs, for whatever reason, the government is left in a very difficult position and cannot effectively govern.

We would imagine that under such a circumstance May would have little choice but to call a fresh general election and request a lengthy delay to Brexit from the EU to would allow for a new parliament to form.

"The defections reduce the government’s working majority in the Commons from 13 to seven, though the defecting MPs have said they will vote with the government on some issues (which probably includes confidence motions). Nonetheless, the risk of a near-term election has risen," says RBC Capital's Cole.

According to betting markets, the risk of an election this year has risen from an already elevated level of 36% to a record 44%.

A general election would open the door to months of uncertainty, with no guarantee that any one side of the Brexit argument will gain a majority in parliament that will allow for a conclusive settlement to the Brexit question.

The Pound detests uncertainty, and under such a circumstance we would warn the currency becomes prone to months of underperformance while more businesses delay investment plans and even trigger Brexit contingency plans i.e. ship operations and capital abroad.

"An early election would presumably be fought under a different Conservative leader (May has committed not to fight the next election) and likely under a more Eurosceptic one. It is hard to argue either an election victory for a more Eurosceptic Tory party, or a Labour-led government would be anything other than negative for GBP," says Cole.

May will hope that further defections are limited and that she will continue fighting for a deal with the EU that can ultimately command a majority in the House of Commons; crucially any deal must satisfy the DUP who say they will withdraw their supply of votes if parliament passes a Brexit deal that threatens the integrity of the UK.

So, we could also end up in a scenario where a Brexit deal has passed (good for the Pound) but the government has lost its majority, thereby forcing a general election (bad for the Pound).

All eyes now turn to the outcome of May's overnight meeting with Jean-Clause Juncker in Brussels.

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