How GBP and FTSE 100 may trade on the UK election

We face the prospect of the UK public voting in yet another election risk for traders to navigate.

bg_pound GBP sterling 01
Source: Bloomberg

The exit polls should start coming in from 07:00 AEST (22:00 BST Thursday) on Friday morning, so it could be very interesting morning here in Asia. I say risk because the probability is that Theresa May and the Conservative Party will get the 326 seats required to gain a majority, although recent polling suggests an increased risk of a hung parliament.

There is little doubt, though, that if the Labour Party can pull off a highly unexpected victory, most likely with the support of the Scottish National Party, it would represent one of the biggest political upsets ever seen in UK politics. While highly unlikely, a Labour-led coalition is not a mathematical impossibility.

The Tories’ lead in the polls has dropped to such an extent that traders have asked “what if” and the election has firmly become a market story. Notably, the YouGuv poll released on 31 May sees the Tories losing their majority and ending up with 310 seats.

In the scenario of a hung parliament, Theresa May would need to reach out to independents and Northern Irish unionists to get the votes to form a government. The Liberal Democrats could form part of a Tory-led coalition, but one suspects they would be loath to work with the Conservatives again after their experience as the minority coalition partner when Nick Clegg was at the helm.

One suspects that a hung parliament will not be taken well by traders, although a Labour government would mean higher taxation on top earners and subsequently increased spending. Labour have also detailed they would allow the deficit to increase through debt issuance. However, the fact we have seen GBP fall at times when we have seen Labour closing the gaps in the polls shows the market will sell GBP on a hung parliament and this scenario could see cable into £1.2500 to £1.2600.

If I look at the options market for expectations of likely market moves this week, we can see GBP/USD one-week implied volatility sitting at 13.9%. While implied volatility has increased of late, which is always going to happen when the expiry covers an election, I don’t think 13.9% is elevated to any great extent and recall implied volatility got above 50% into the Brexit vote. In fact, if we look at IG’s pricing for a £1.2900 (at-the-money) GBP/USD ‘straddle’ expiring on Friday it is costing 200 points. What this basically details is the fact the market is priced for a cable to move 200 pips in either direction from current levels. This seems fair and traders can use this expected move to buy and sell volatility.

This pricing feels to me that the market is priced for the Conservatives to gain a majority, with the party likely to pick up somewhere between 50-80 seats. This would be well off the levels many were talking about two months ago when the snap election was called, but would still cement the Tories position in the Commons, meaning Theresa May would hold office after the UK actually leaves the European Union. So in this scenario, GBP/USD is expected to trade towards the May highs of £1.3048 and into £1.3100 and perhaps higher if we see the Tories get a strong majority of over 100 seats.

Another interesting debate is how the FTSE 100 trades if we see a Conservative majority, which as I say is still the likely scenario priced by markets. If GBP rallies, this could become a headwind for the FTSE 100. Recall at the extremes in November we saw 80% of the variability in the FTSE 100 explained by currency moves, although that inverse correlation between the GBP and FTSE 100 has not really been in play for a few weeks now. However, there are signs it may re-exert itself and we can look at the day Theresa May called the snap election. We saw GBP/USD rally 2.2% and the FTSE fall 2.8%. More recently we saw the YouGov poll predicting a hung parliament and cable fell 0.5% while the FTSE rallied 0.13%.

So while the inverse correlation (between GBP/USD and FTSE 100) is not in play right now, I suspect that if we see a strong showing from the Conservatives, the GBP will rally against all crosses and the FTSE 100 will attract sellers given FTSE 100 companies source such a large amount of revenue from outside of the UK.

The question then of how this affects the EU negotiations is firmly a discussion point and tactically any moves into £1.3200 to £1.3200 would present a good selling opportunity. A strong majority for Theresa May increases the prospect of this so-called ‘hard Brexit’ and, while this is likely priced in to a great degree, I still feel this should offer traders a good opportunity to sell GBP/USD if it rallies into these levels. Long EUR/GBP is also looking quite attractive.

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