Kamal Sharma, Research Analyst at Bank of America Merrill Lynch, points out that the FX markets appeared to be overly complacent with prevailing opinion poll data, suggesting that the Conservative Party would return to power with an enhanced majority.

Key Quotes

“Market complacency on expectations for a sizeable majority was one of the motivating factors behind our view that GBP was likely to face near-term headwinds in the coming months as investors “buy the sizeable majority, sell the fact”. Unsurprisingly, a narrowing of the polls has seen GBP TWI fall by over 3%, peak-to-trough in May.”

“Large Conservative Victory (Market Consensus):  With market nerves having increased in the final weeks of the campaign, we believe that a large Conservative victory would be initially bullish for GBP as it would remove the political uncertainty that has been building. GBP TWI could potentially bounce by around 3%, effectively recovering the losses in recent weeks when the polls tightened. Nonetheless, we are not convinced that the GBP rally can be sustained. Large majorities are no guarantee that GBP will sustain its gains and with UK growth stalling, market complacency over the start of Brexit negotiations and positioning now broadly neutral, our bias would be to sell GBP rallies.” 

“Small Conservative Victory: Relative to market expectations, this would be seen as disappointing for GBP and though there would be some initial relief, we believe that this would prove very shortlived. Markets reacted positively to election announcement on the assumption that an enhanced majority for the Conservatives would potentially dilute the more extreme views on Brexit within the parliamentary party. Given the tendency for majorities to whittle down through the course of a Parliament, May’s majority could look less stable heading into the climax of the Brexit negotiations.”

“Labour-led Coalition: Political uncertainty is generally fertile ground for weaker currencies and higher FX volatility. Despite the hard Brexit narrative that has prevailed since May assumed power, markets have broadly welcomed the government’s position as providing clarity on its intentions. A hung parliament with a Labour-led coalition as the only viable option would initially be negative for GBP in our view. However, we believe that whilst a potential coalition would likely be dominated by the Labour Party, the quid pro quo for support from other parties (potentially SNP and LibDem) could be a commitment to hold a second Referendum and the market perception that a softer Brexit is more likely. We believe that markets will focus on the implication of such a coalition through the Brexit lens. In this regards, any dips in GBP may be seen as buying opportunities.” 

“Labour majority: We think the initial GBP reaction is likely to be a steep decline and probably more protracted than in our coalition scenario (GBP TWI -5%). GBP weakness could persist for longer as markets digest the full implication of Labour’s macro policies. But as stated above, for FX markets, Brexit will likely be the dominant driver of subsequent moves and here we think that the initial sharp decline in GBP could be tempered if a Corbyn administration decides that its domestic policy agenda will take precedence over the Brexit agenda. Should it become clear that the Labour administration is moving towards a preference for Single Market access and therefore a softer Brexit, we think there is scope for a strong GBP recovery. However, beyond a potential “soft-Brexit bounce” in GBP, we think that the UK Achilles Heel of its large current account deficit could be brought into focus over the medium-term, given our concerns about funding spending and corporation tax hikes.”

How could the UK general election affect the Forex Market?

Conservative victory with Absolute Majority (Scenario 1)

A Conservative victory with an absolute majority should be supportive initially for the pound. Stock markets would be relieved on the lower corporation tax outlook and a risk-on environment could be the expected outcome. However, with a focus on Brexit and PM May's hardline - "No deal is better than a bad deal" - approach to the negotiations, a hard Brexit outlook could equate to a bearish scenario to the pound eventually - (Note: Remain cautious of a 'buy the rumour sell the fact' trade - a Conservative victory is virtually priced in).

Conservative victory without Absolute Majority (Scenario 2)

With the narrowing of the polls and a trend that has been continuing, the possibility of a hung parliament should not be ruled out, (When no party has won enough seats to have a majority in the House of Commons). Such an outcome could be highly bearish for the pound due to the uncertainty for markets to deal with. However, in a hung parliament, the incumbent prime minister stays in office until it is decided who will attempt to form a new government - this could support the pound after an initial sell-off. (Note: A hung parliament does NOT necessarily mean a coalition government). 

Laborist victory (Scenario 3)

A balanced outcome for the pound with initial volatility on the basis of Labour’s manifesto. Initially, a lower pound could be the immediate outcome bias due to increased uncertainty and a reduction of inflows. However, a Labour victory should mean a softer Brexit outlook and austerity would be removed, (Fiscal easing lifting growth and inflation expectations). Higher real yields may offset the initial weakness in the pound. 

When is the UK general election 2017?

The United Kingdom snap general election is scheduled for June 8, 2017. The election will elect representatives for the 650 districts that make up the House of Commons, the lower house of the British Parliament.

Theresa May Called for UK Snap General Election

UK Prime Minister Theresa May has announced plans to call a snap general election on May 15th. Explaining the decision, Mrs May said:  "So we need a general election and we need one now. We have at this moment a one-off chance to get this done while the European Union agrees its negotiating position and before the detailed talks begin."