Macquarie: How different UK election scenarios will affect the pound sterling

  • If U.K. Prime Minister Theresa May wins the election on Thursday and expands her parliamentary majority, the pound should rally in the short term, Macquarie said in a note on Thursday.
  • If the election results in a hung parliament, that would likely spur a softer Brexit, but the pound will likely fall on increased uncertainty, Macquarie said.

If U.K. Prime Minister Theresa May pulls off an election victory on Thursday, the pound will likely stage a rally, analysts at Macquarie said in a note on Thursday.

"Any preliminary count headline that suggests Prime Minister May is on course to expand her parliamentary majority should be a pound-positive," Macquarie analysts Nizam Idris, Gareth Berry and Teresa Lam said.

That's counter-intuitive, they noted, as May has "championed" a hard Brexit, but Macquarie said that's how the market has traded the pound risks since April 18, when the snap election was called.

A hard exit from the European Union, or hard Brexit, would come if the U.K. fails to reach a deal with the continent and leaves the EU's lucrative single market, reverting to World Trade Organization (WTO) rules.

The pound has dropped from as high as $1.50 against the dollar just before the June 2016 vote to exit the European Union to as low as $1.1979. At 10:20 a.m. HK/SIN, the pound was fetching $1.2959. But Macquarie expected that any post-election pound rally could be short-lived.

"We think the sterling downtrend could resume within days though, as May's new cabinet is named and EU-U.K. negotiations get underway," Macquarie said.

But Macquarie noted it couldn't rule out a scenario for a hung parliament, which could weigh on the currency.

When May "reluctantly" called the June 8 snap election seven weeks ago, the Conservatives boasted a seemingly unassailable lead over the left-wing Labour. However, Labour leader Jeremy Corbyn has since soared into contention, putting May's election gamble to gain a stronger majority and Brexit-negotiation mandate in doubt.

Postcards showing the British Union flag, also known as Union Jack, sit on display at a souvenir store near to the Elizabeth Tower, also known as 'Big Ben', in London, U.K.
Luke MacGregor | Bloomberg | Getty Images
Postcards showing the British Union flag, also known as Union Jack, sit on display at a souvenir store near to the Elizabeth Tower, also known as 'Big Ben', in London, U.K.

While a vast majority of observers still expect May to emerge victorious on Thursday, a Survation poll published last weekend placed the prime minister's ruling right-wing Conservative Party ahead by just a single percentage point.

In a hung parliament, with no party taking a clear majority, the U.K. could be thrown into a political deadlock with less than two weeks before formal Brexit talks were due to begin on June 19.

Macquarie noted that the U.K.'s "first past the post" system has meant elections were hard to call as the popular vote map doesn't always match which seats were won and lost.

"There is a real risk that this general election could be used as a second referendum on the U.K.'s future relationship with the EU – a last gasp attempt to stop Brexit in its tracks," Macquarie said.

"If a hung parliament does materialize, we think it could ultimately lead to a softer Brexit. But ironically, sterling is likely to fall initially."

Macquarie noted that creating a new governing coalition would likely take weeks of "horse-trading" and "intense" uncertainty.

It also created the risk of a second referendum on Scottish independence, which would weigh sentiment, the analysts said.

In a 2014 referendum, Scotland voted to remain a member of the U.K., but the region also voted overwhelmingly in 2016 against Brexit, spurring rumblings of a fresh referendum.

Bank of America-Merrill Lynch was partially on-board with Macquarie's view.

"With market nerves having increased in the final weeks of the campaign, we believe a large Conservative victory would be initially bullish for pound as it would remove the political uncertainty that has been building," the bank said in a note on Wednesday.

The bank also didn't expect that any pound rally would be long-lived, even if the Tories pull off a sweep.

"Large majorities are no guarantee that the pound will sustain its gains and with U.K. growth stalling, market complacency over the start of Brexit negotiations and positioning now broadly neutral, our bias would be to sell pound rallies," the bank said.

If Labour manages to pull a rabbit out of a hat and take the majority, Bank of America-Merrill Lynch expected the pound would initially suffer a "steep" fall.

"Brexit will likely be the dominant driver of subsequent moves and here we think the initial sharp decline in the pound could be tempered if a Corbyn administration decides that its domestic policy agenda will take precedence over the Brexit agenda," it said.

"Should it become clear that the Labour administration is moving toward a preference for single market access and therefore a softer Brexit, we think there is scope for a pound recovery."

—CNBC's Sam Meredith contributed to this article.