British Pound Oversold as Markets Overplay May's Vulnerability

One persistent driver of the British Pound's under-performance in October has been the vulnerability of Theresa May's grip on power. Markets May need to reasess their negativity on this front.

Markets have feared a challenge to Prime Minister Theresa May's leadership in recent weeks, with many suggesting the issue poses a new front of uncertainty that has increasingly weighed on the Pound.

The argument has gained traction this week as the Conservative Party conference got underway, with heightened focus on the issue being blamed by some for Sterling's poor performance thus far in October.

Of particular interest is the drama surrounding Foreign Secretary Boris Johnson who has on occassion waded into the Brexit debate, a topic beyond his ministerial remit, which has been interpreted by some as a testing of the waters for a possible leadership bid.

"The Conservative Party Conference... also poses a risk event, where signs of a split within the Tory Party may weigh on GBP as it raises concerns about PM May's leadership,” says Hans Redeker, a Strategist at Morgan Stanley.

Redeker recently advocated traders sell the British Pound and buy Euros, partly on the basis that May's week grip on power posed a threat to Sterling.

"Political unrest throughout the UK government gives the market little confidence as Prime Minister Theresa May faces a potential leadership challenge," says a briefing from brokers International Foreign Exchange, explaining Sterling's recent soft performance.

Nerves are evident in the market, with the Pound-to-Euro exchange rate down from a best of 1.1360 at the start of the week, to 1.1271 at present.

The Pound-to-Dollar exchange rate is down to 1.3263, at the time of writing, having been as high as 1.34 at the start of the week.

Kit Juckes, an analyst with Societe Generale, notes "Embattled Theresa May came under additional fire as Tory party divisions over Brexit reopened. The cabinet infighting over the future UK-EU relationship is buoying EUR/GBP in the face of the Euro correction. The bone of contention is whether the UK should seek regulatory convergence with the EU in order to secure a close trading relationship after Brexit."

So, the question of May's tenure at the top is a key one for the value of Sterling in the near-term.

But this Theme is Overplayed

With the Pound seemingly under pressure over the issue of Theresa May's tenure, what would happen if it were confirmed the Prime Minister is in fact secure in her position?

This could be the case and, if so, the Pound might be due a comeback if markets also buy this view. Indeed, all evidence suggests there is little chance of May being deposed, certainly not prior to the delivery of Brexit.

Since the start of the conference delegates have gotten behind May, with senior figures on the 1922 Committee saying the party would back any attempt by Theresa May to sack Johnson.

The 1922 Committee represents the views of Conservative lawmakers who do not have ministerial positions, but is seen as the centre of party power in parliament. Its backing is key as Johnson cannot move forward without their support.

Furthermore, other members of the cabinet have backed May and claim they will not entertain the prospect of a change in leadership. 

If the Conservative Party deposes its leader it risk another general election, which might cost them power. So while members of the party seeking a so-called hard-Brexit might fight for their views to be heard - as is the case with prominent parliamenterian Jacob Rees-Mogg - the chances of them actually forcing a changing of the guard are seen as slim.

So perhaps traders, analysts and market commentators have just been caught up in the media hype concerning the May-Johnson psychodrama?

If it becomes clear the shape of the UK Government is unlikely to change, it is possible some of the risk premium absorbed by Sterling may dissipate and support for the currency be established once more.

However, a more sustained recovery could be unlikely at this juncture as further layers of political uncertainty remain - namely Brexit talks, where traders are waiting to see a convergence between the UK and EU positions.

Having witnessed negotiations thus far, may say the UK must yield further to Brussels so May's speech on Wednesday will be watched for further concessions.

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Danger, Details and A Transition to Nowhere

Moving talks on to the question of future trade could be more crucial to the government’s Brexit strategy than markets currently appreciate.

While May’s cabinet is hoping the EU will agree to the concept of a “transitional period”, it is important there are concrete details of the future relationship on the table before this can happen otherwise, talk of an implementation period amounts to a request for a transition to nowhere. Political figures on the opposite side of the English Channel may not want to agree to this.

“Given the political capital required from the EU27 to agree on EEA transition, member states may resist the prospect of a possible 'transition to nowhere,” says Oliver Harvey, an analyst with Deutsche Bank.

Harvey identifies PM May’s Florence pitch for a transition period as likely to result in the UK entering the European Economic Area, presumably under some kind of associate membership, during the implementation period.

“But the greater the emphasis the EU27 place on the outline of a future free trade deal to move talks onto transition, the more difficult this will make life for May, given ongoing divisions within the Conservative Party,” Harvey argues. “ If the EU pushes for a more detailed understanding of this future relationship, a political crisis is highly likely, and uncertainty will be prolonged.”

May will deliver her speech from Manchester Wednesday although a precise time is yet to be scheduled.

Concessions Ahead

Another key development on the agenda is how the Prime Minister addresses Brexit in her mid-week speach to the Conservative Party conference. 

If May concedes further ground to the EU during Wednesday’s speech it might go some way in pushing negotiations onto the future trading relationship in the near future.

MEPs in the European parliament and disgruntled Conservative Party members are sources of two opposing pressures on Prime Minister Theresa May, and a downward force on the Pound of late.

The European parliament delivered a non-binding vote against Brexit talks proceeding onto the subject of trade Tuesday, due to “insufficient progress” in the divorce negotiations.

PM May's speech in Florence was not enough to achieve "sufficient progress". I hope her speech to #cpc2017 will bring more clarity.

— Guy Verhofstadt (@GuyVerhofstadt) October 3, 2017

This was less than 24 hours before PM May is set to deliver a keynote speech at the Conservative Party conference in Manchester.

"Everybody can understand, Europe is not going to pay w/ 27 what has been committed by 28." @GuyVerhofstadt on Financial Settlement. #Brexit pic.twitter.com/cXZsVijuIq

— ALDE Group (@ALDEgroup) October 3, 2017

Expectations are that May will concede further ground to EU negotiators but, regardless, Tuesday’s vote in Brussels was no doubt an attempt to heap further pressure onto the embattled PM. But this hasn’t prevented the Pound from coming under renewed pressure during the week to date.

“We think May will be able to converge towards the EU27 on financial liabilities and citizens rights without triggering a destabilizing leadership challenge,” says Oliver Harvey, a macro strategist at Deutsche Bank. “This would in turn overcome the 'sufficient progress' hurdle presented by Barnier and likely trigger a positive from markets.”

At the heart of Brussels’ concern is a fear the EU will not be able to finance its budget commitments between when Britain is scheduled to leave in March 2019 and the end of the EU budget period in 2020.

The post-Brexit rights of EU citizens living in the UK and UK citizens living in the EU are still uncertain despite efforts to reach a deal. Direct or indirect ECJ oversight of British courts when it comes to enforcing citizens rights is a key demand of Brussels.

But Brexiteers within the Conservative Party have opposed the idea of the ECJ having any jurisdiction in the UK during and after a transitional period.

“Because of the continued support of institutions like the Treasury for a status quo transition, we believe it is most likely that May converges,” says Harvey.

If May does as some strategists suggest and concedes further ground to the EU Wednesday then the short term reaction from Sterling will be positive while broader fears over the durability of her leadership are probably excessive.