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Investors are underestimating the potential for the U.K. government to "implode," resulting in a snap general election, a senior foreign exchange strategist told CNBC.
Sterling volatility has fallen sharply in recent weeks after Brussels and Westminster agreed to delay Britain's departure date by up to six months, removing any immediate risks of a no-deal Brexit. Such an eventuality would have hit the pound by as much as 10%, according to Jeremy Stretch, the head of G-10 currency strategy at CIBC.
Consequently, bets against the pound — known as short-selling — have pared to nine-month lows, but analysts still remain bearish on the outlook for sterling in all Brexit eventualities. The pound has gained nearly 2% on the dollar since the turn of the year but it started this week below $1.30 as the British parliament returned from its Easter break.
Stretch pointed to a lack of substantive progress in negotiating the stalemate between the Conservative government and the opposition Labour Party as driving this caution.
"Ongoing political uncertainty raises the prospect of a perpetuation of precautionary saving (at the expense of spending) and postponement in business investment, impacting underlying growth potential," Stretch said
"The risk of the Brexit process extending towards October 31 risks taking the Bank of England out of the equation in 2019, underlining that for now, ongoing Brexit paralysis favors significant sterling impetus proving to be delayed, if not yet derailed."
Stretch suggested that a negotiated exit remains the most likely outcome, and although the timing of such an event remains unclear, the tail risks of a hard Brexit remain modest.
Crucially, the potential for an internal leadership contest within the governing Conservative Party, or a fresh general election carrying with it the possibility of a coalition government led by Labour leader Jeremy Corbyn, would see a "substantial retreat in sterling sentiment," Stretch suggested.
A BBC report Tuesday suggested Prime Minister Theresa May could face another vote of no confidence from grassroots campaigners within her own party over her handling of Brexit.
More than 70 bosses of local Conservative associations have reportedly signed a petition calling for an unprecedented general meeting to hold a non-binding vote of no confidence in their leader. May survived a vote of no confidence from her own MPs (members of parliament) in December.
"We would view the market as underplaying the risks of a snap election should the Conservative government threaten to implode," Stretch said.
Meanwhile, Jane Foley, the Rabobank head of foreign exchange strategy, added that a report in The Telegraph newspaper, which revealed that staunch Brexit supporter Boris Johnson has a 17-point lead amongst Conservative Party membership as the next prime minister, would further unsettle the pound.
"The impact is most obvious in business investment which implies slower growth and higher inflation potential going forward," she told CNBC. "The disappointing level of daily turnover in the FTSE is also evidence of this."
Foley said the pound would need to see strong evidence of progress in cross-party talks in order to cast aside fears over U.K. economic performance and Conservative Party leadership.
A second referendum has seemingly increased in probability in recent weeks, but it is not being treated as a central case scenario for analysts, and investors drawing on experience may still be reticent to jump the gun.
"While proponents of a second vote argue that it would be predicated upon more informed opinions compared to that in June 2016, markets may remain wary of reading too much into another vote," said Stretch.
"Pollsters have the precedent of the 2016 poll to work from, this should improve poll accuracy, but with issues such as turnout remaining critical to the outcome investors may be reluctant to buy sterling aggressively on any referendum announcement, albeit we would expect modest topside impetus to be the immediate result of any fresh vote being called."
A longer Brexit delay might also be politically detrimental to the remaining members of the EU, according to Stephen Gallo, European head of foreign exchange strategy at BMO Capital Markets.
"Ironically, the politics of a long Brexit delay could have bigger economic implications for the EU than the U.K., because the euro zone is one giant 'cliff edge'," Gallo said. "In other words, in the context of a potential U.S./EU trade war, the EU elections risk leaving euro zone economic policy and governance rudderless."
Gallo holds a neutral-to-negative bias on both the euro and sterling over the coming three to six months. The end of that window falls on the verge of the renewed deadline. He believes that the 1.1375/1.1400 area in EURUSD looks like a good opportunity to be short, as does the 1.3150/1.3200 area in GBPUSD.