Sterling’s Move Suggests a Softer Ride in Brexit
Posted by hkarner - 20. April 2017
Source: The Wall Street Journal
Pound had a fine day against dollar after Prime Minister Theresa May called for snap election
It is hard to put probabilities on political outcomes, but the reaction of sterling on Tuesday to the calling of a snap U.K. election offers one rough measure: It is now about 10% less likely that British politicians will take the economy outside and shoot it in the head.
The pound had its second-best day against the dollar since last summer’s vote to leave the European Union, after Prime Minister Theresa May on Tuesday went back on repeated promises not to call a sudden election. At a time when investors are obsessed with politics, this calls for some explanation.
It starts with the slim majority Mrs. May commands in Parliament, and the fractious nature of many of the Leave members of her party. They have been calling for a “hard Brexit,” leaving the EU quickly even if it means falling back on unfavorable World Trade Organization tariffs and cumbersome customs procedures. The smaller her majority, the more power held by these backbenchers and like-minded ministers.The election offers a chance to shake things up in her party. The Conservatives are way ahead of the imploding opposition Labour Party, and while the pro-European Liberal Democrats will put up a fight, Mrs. May’s majority is likely to increase substantially.
The 2.4-cent rise in the pound from the New York level late Monday recovers almost one-tenth of the loss since the Brexit vote, to leave sterling buying $1.28 by the evening in London. Hence the rough estimate of a 10% lower chance of Conservative rebels forcing Britain to swallow a hard Brexit and all the disruption—and weaker currency—that would come with it.
There are three big drawbacks to the calculation. First, it doesn’t tell us the actual probability, only the change. One way to estimate the level is to look to the options market. An extreme outcome might be the pound dropping below $1.10 in the next year, which Alan Ruskin, co-head of foreign exchange research at Deutsche Bank AG, calculates the options market puts at less than one in 10.
Second, the election provides another benefit in the form of time. The next election had been due in 2020, with the Conservatives wanting to be out of the EU by then. After the snap June vote, Mrs. May won’t have to go to the voters again until 2022, easing the pressure from the British side to rush through the talks (although there may still be pressure from Brussels to get it over with before the earlier European Parliament elections.)
A third reason for caution is that this is a snap judgment from markets on the snap election. Benjamin Graham, Warren Buffett’s mentor, famously said that markets in the long term are a weighing machine, but in the short term, a voting machine. It is hard for speculators holding what are still very large bets against sterling impartially to weigh the probabilities, so the instant votes likely were just to join the buying in order to close out the trade. Such short covering briefly pushed the pound above $1.29 for the first time since October.
If the election as expected delivers Mrs. May her big majority, it will narrow the range of outcomes from the U.K. side of the Brexit talks, and mean Mrs. May’s own—unknown—views will matter a lot more. Unfortunately for sterling investors, the election does nothing at all to change the outcomes from the European side, where tough talk is still the order of the day.