UK election: what now for the pound as UK referendum fears start to rise?

May 8, 2015

The shock election victory for the UK’s Conservative Party triggered a rally in UK asset classes on Friday; however, in the aftermath of the election questions are being asked about the future of the UK’s EU membership now that the Conservatives are firmly back in power.

Prime Minister David Cameron mentioned his pledge to hold an EU referendum before the Conservative majority had been confirmed and warnings from elsewhere about a potential referendum have started to come thick and fast. The UK’s banking body urged caution and stressed the need to ensure that the financial sector is protected if the UK leaves the EU. Credit rating agency Moody’s released a statement earlier and said that a referendum could have implications for the UK’s credit rating. Thus, just because the Conservatives have a majority in the UK and it is considered a “business-friendly” party does not mean that financial markets will stay sanguine with Cameron for the long-term.

But are markets worrying for no reason? We think that they might be for a couple of reasons:

If we do get a referendum in 2017 don’t automatically trust the opinion polls that got it catastrophically wrong in this election and could do so again. People may say they want to leave the EU, but might lose their nerve in the polling booth.
This election saw the majority of the electorate (38%) vote for the status quo. Thus, at this juncture in UK’s economic recovery the electorate chose not to rock the boat and change leadership. The status quo bias could also determine the outcome of an EU referendum, as a large number of voters will not have lived through a time before the UK was part of Europe.

So what about the pound? After a shock election result, the market may need to rethink its view on the medium-term outlook for the pound. Below are our thoughts:

The pound had a 250 pip bounce on the back of the UK exit polls, which predicted a Tory victory.
This was a decent move, but does not suggest euphoria in the financial markets on the back of the Conservative win. The FX market may have held back due to EU referendum fears.
Overall, domestic factors could play second fiddle for the pound, as the dollar and speculation about US interest rates are key drivers of the FX market this year.
Due to the above point, if UK yields continue to move higher on the back of global factors then this could support GBP going forward.
We think that the failure to significantly break above 1.55 is significant, and suggests we could be range-bound in cable between 1.51-1.55 for the next few weeks.
In contrast, the election result could have a longer term impact on the stock market as fears about a potential Labour government raising taxes, hiking the bank levy, and limiting increases in utility prices  has been eradicated. If this positive sentiment could be maintained then we could see fresh record highs back above 7,122 for the FTSE 100 in the coming weeks.

It is also worth noting the reaction in bond yields. UK 10-year Gilt yields have actually fallen in the aftermath of the election result, in line with global yields which have also fallen back after some large increases in yields earlier this week. However, the decline in Gilt yields/ rise in Gilt prices could also be the market breathing a sigh of relief that political uncertainty in the UK has been eradicated for another 5 years.

Overall, in the short term the election result is positive for sterling, but in the longer term it could struggle to make gains towards 1.60 if the spectre of an EU referendum starts to loom large.

Figure 1:

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