Labour Minority Government most Pound Sterling Friendly Outcome of Election: Deutsche Bank

• FX Market Quotes (6-6-17):
• Pound to Euro exchange rate: 1.1483, up 0.14%, day's best: 1.1487, day's low: 1.1451
• Pound to Dollar exchange rate: 1.2915, up 0.10%, day's best: 1.2950, day's low: 1.2892

The British Pound is seen putting in a strong performance at the start of a week that sees the UK go to the polls in order to vote in a new Government or give their backing to Theresa May's Conservative's once more.

The strenght of the Pound comes against a backdrop of a narrowing of the Conservative party's advantage in the polls, inviting much speculation from analysts in the foreign exchange community as to how the British Pound might act on Thursday night / Friday.

"Investors will treat GBP trading with caution ahead of the event," says Chris Turner at ING Bank N.V. "We see potential for some political risk premia to be priced into GBP ahead of the event. The main risk to GBP is an even smaller Conservative majority or a hung parliament."

For now markets are giving May the benefit of doubt with a ten poll moving average showing the Conservative’s advantage over Labour now stands at 9 points, versus 18 points four weeks ago and 10 points on Monday.

Yet markets are clearly showing a bias to the Conservatives winning big.

“We expect the Conservative Party to have a overwhelming victory, which may underpin GBP despite rising volatility,” say CitiFX in a brief to clients. “Whether the Conservative Party can expand its advantage is significant for Brexit procedure. Markets are focusing on this election. GBP volatility may increase in the short term.”

Citi are forecasting the Conservative to win at least 109 seats.

Electoral Calculus has the Conservative majority on 72 and we suspect this will rise in the wake of the Question Time performances seen on Friday.

There is also the question of how the weekend terror attack in London will impact the vote if voters place security higher on their agenda. Polls covering public opinion in the aftermath of the attack are released on both Tuesday and Wednesday,

Security is a weak spot for Corbyn and we might just have seen peak-Corbyn following both events. Yet, the opposition and media are making much of Theresa May having overseen a reduction in police posts by 19 000 - how will it play?

“The last three weeks has been traumatic for the Conservative campaign as attention has veered off Brexit and onto unpopular Conservative policies on social care and education, and questions about the leadership of Prime Minister May,” says Oliver Harvey at Deutsche Bank.

Nevertheless. Deutsche Bank are expecting as a base-case scenario a “market-friendly 50/60 seat Conservative majority,” but warn any “further narrowing would make this outcome uncertain, and the most recent polls suggest the lead may be continuing to narrow,” says Harvey.

Deutsche Bank’s Five Scenarios for Pound Sterling

As mentioned, the base-case scenario would be the Conservatives extending their parliamentary majority.

But, in a research note released on June 3 Harvey says the most Sterling-friendly outcomes is in fact a Labour minority government with SNP and Liberal Democrat support, followed by a strong Conservative majority of above 50/60 seats.

By contrast, the most Sterling-unfriendly outcomes would be a Conservative majority of below 50/60 seats, or a Conservative minority government.

Scenario 1: Conservative majority less than 50 but above the current 17 – Strong sterling negative.

PM May is likely to retain power, but without the majority needed to conduct negotiations effectively.

The influence of hard-Brexit MPs over looming issues such as the divorce bill would be large and the chances of reaching a deal with the EU low.

The purpose of an early general election would have been negated, and the starting point of talks would be worse given the ramping up of rhetoric with the EU27 during the election campaign.

Significant economic weakness and/or market pressure would once again be required to secure a transitional deal, or the UK would crash out of the EU in March 2019.

Scenario 2: Conservative majority less than current 17 – Strong sterling negative.

May’s support within the Conservative Party is highly contingent on electoral success.

The right of the party (already unhappy at her unopposed victory in the leadership contest last year) may launch a challenge if the Prime Minister did not herself resign.

A hard Brexit candidate would have a good chance of winning a leadership election.

In the event May stayed on for continuity, her political authority would be severely undermined and the same political constraints would apply as in scenario 1.

Scenario 3: Conservative minority government – Moderate Sterling negative.

If the Conservative Party fall short of an overall majority, but remain above 300 seats, this could see a Conservative minority government.

While there would appear to be little prospect of compromise with other parties on the Conservatives’ current Brexit plans, it is also unlikely that the right of the Conservative party would tolerate a much softer approach to Brexit.

This government would prove highly unstable, and the most likely outcome is a new general election.

We view this as a market negative, given the uncertainty generated and lost time for Brexit negotiations.

Scenario 4: Rainbow coalition/Labour minority government – Sterling positive.

In the event that the Conservatives dropped below 300 seats, a workable majority between the Labour Party, SNP, the Liberal Democrats, Green Party and Plaid Cymru may be possible.

The initial market reaction could be to sell the Pound, but the medium term implications would be more bullish.

We find this view from Deutsche Bank to be quite surprising particularly as questions will be asked over such a government’s fiscal credibility.

But with an eye on Brexit Harvey believes the UK will stay within the customs union and the EU single market.

It is argued that the support of the SNP, Liberal Democrat, Green and Plaid Cymru parties for a Labour government would be conditional on a ‘soft Brexit’ approach, such as EEA membership, and perhaps a second referendum on EU membership.

The spending plans set out in the Labour party’s manifesto are also seeing as being stimulative to the economy - public sector pay rises and the rising of the minimum wage to £10 an hour will likely boost wage inflation and illicit an interest rate rise from the Bank of England.

However we question what the offsetting impact of that rise in minimum wage and the 6% hike in corporation tax will have on business profitability and investment intentions.

“We see the prospects of a softer Brexit and fiscal stimulus outweighing the impact of policies such as rises to corporation tax rates. We do not see SNP influence as necessarily leading to a second Scottish independence referendum,” says Harvey.

That the Scottish Nationalists would not get a second referendum in return for supporting a minority government is naive. The SNP’s core focus is independence and this will certainly be secured by Sturgeon and her government.

But Harvey argues that if a soft Brexit or second Brexit referendum is achieved, the SNP leadership may in fact rescind their demand for a second Scottish independence referendum.

Scenario 5: Labour Party Majority – Impact on the Pound Unclear.

Deutsche Bank see this as the most unlikely scenario.

Labour Party policy towards Brexit is softer (to secure the benefits of Single Market Access and a more open immigration policy than the Conservatives), but detail is thin and delivery may be an obstacle.

It would also be questionable to what extent a softer Brexit policy would be outweighed by less market friendly policies such as rises to corporation tax and higher public spending.

By contrast, as noted above, easier fiscal policy may lead to a more hawkish Bank of England which would traditionally be good for the Pound.

But for now the uncertainty that his radical policies will have on the long-term performance of the economy is large.

And we know the Pound hates uncertainty more than anything else.

Four Days to Go: Where do the Polls Stand?

This week’s election is closer than many expected though bookies are still ~75% priced for a Conservative majority.

This despite YouGov's new polling system suggesting May will fall well short of a majority.

The Electoral Calculus website - the original parliamentary seat predictor - shows a 72 seat majority, though also gives a 33% probability that it doesn’t happen at all.

The first solid insight into the outcome will be clear by 10pm BST with the exit poll release.

If it is close however, we will have to wait until ~1am for the results from key marginal and ‘target’ seats.

Weekend polls ranged from a 11% lead for the Tories to just 1%.

"Bottom line a Tory majority is still the most likely outcome but as one electoral tracker put it we are a “normal-sized polling error” away from a Labour majority or hung parliament. The risks to GBP are also asymmetric, given markets are still priced for a Tory victory despite the narrowing race," says Adam Cole, an analyst with RBC Capital Markets.