The U.K's surprise general election result left the ruling Conservative Party without a majority and many investors without a clue on how the pound will react as political events unfold.
There are many ways Britain's political situation could pan out as the Conservatives scramble to form a government following their failure to win a majority in Thursday's poll. That is important for a country about to begin it is divorce from the European Union, its biggest trading partner.
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Each outcome offers a different path for sterling, which tumbled by as much as 2.4% against the dollar after the exit polls came in.
"In recent European elections it's been very clear in terms of outcomes for markets--good or bad--this time it's far more foggy," said Antoine Lesne, head of strategy and research in Europe for SPDR ETF.
Here are a few of the scenarios investors are currently trying to game:
A Weakened Conservative Government
Strategists are torn about what a Conservative minority government means for the pound, though this is the most likely outcome of the vote.
Sustaining that government would require full backing from the Conservatives' own lawmakers and support from the Democratic Unionist Party--a Northern Irish party with 10 members of Parliament that, like the Conservatives, wants to leave the EU.
Some investors believe that outcome would lead to a stronger pound, as the government would be forced into a more conciliatory position with the EU. Most investors believe that Brexit will be bad for the British economy, given its potential effect on trade and the country's large finance industry.
"We would caution against chasing (the pound) lower from here. Today's result will in part be seen as a vote against a definitive break from the EU," said John Wraith, head of U.K. rates strategy at UBS. "A Tory minority may have to make concessions in the direction of a softer exit."
But others believe that political uncertainty may overwhelm any optimism about the potential for a so-called soft Brexit and keep pressure on sterling.
"Regardless of a possible arrangement with DUP--the new government won't have a strong mandate from the get-go," said Rabobank in a research note. "As the position of the new government emerges, the currency could be in for a rocky ride."
Analysts at HSBC predict that sterling will hit $1.20 by the end of the year, even with a Conservative-led government.
A More Powerful Labour Party
A minority government led by the Labour Party now seems unlikely. With 261 seats, even support from other parties wouldn't bring Labour to 316 seats, the number needed to get a majority.
If Prime Minister Theresa May fails to form an administration, the Labour Party would get a crack at it.
Some analysts see a minority Labour government as the most sterling-positive outcome. While both the Conservatives and Labour say Brexit should still happen, Labour is expected to adopt a more conciliatory approach with Brussels. J.P. Morgan's foreign exchange strategists predict it would push the pound 2% to 3% higher from pre-vote levels.
"It could ultimately lead to a far less disruptive Brexit," the bank said.
In any case, a slim conservative majority could leave the Labour Party with more influence over the shape of Brexit. If the Conservative's more pro- or anti-EU lawmakers refuse to back Mrs. May on Brexit she may have to call on Labour, which has so far stuck to its position on the issue.
"The possibility of a soft Brexit holds the promise of a more constructive view on sterling," said Paul O'Connor, head of multiasset at Janus Henderson. "But the fog of domestic political uncertainly will need to clear before much faith can be placed in that scenario."
No Functioning Government
The most negative outcome for sterling may be if it takes a long time for any government to form, something that happens relatively regularly in continental Europe and could lead to another election. The U.K. was set to began negotiating the two-year period of exiting the EU within two weeks, and the longer it takes for a new administration to form, the longer the clock ticks.
"Another election could be pursued later this year. This injects huge uncertainty into markets and will lead to volatility," said Charles Hepworth, investment director at GAM. "In our view, this is the worst possible outcome for the markets in the short term."
Though the U.K. can ask for the two-year negotiation period to be extended, that would require the unanimous agreement of all EU states.
"The longer this goes without a resolution, the more uncertainty there is," said Viraj Patel, foreign exchange strategist at ING, who sees the pound falling to $1.25 or $1.24 under that scenario.
Write to Mike Bird at Mike.Bird@wsj.com
(END) Dow Jones Newswires
June 09, 2017 11:14 ET (15:14 GMT)