Pound faces another bout of volatility with UK election

A day ahead of Britain's general election, investors are cautious of a vote that seems tighter than anticipated and could have long-standing repercussions on the country's exit from the European Union and its economic outlook.

For the British pound, it could be particularly impactful.

The currency, long one of the key elements of the international financial system, has suffered bouts of volatility since Britain's vote last year to leave the EU and is likely to be the focus in markets as the results come in.

When Theresa May made her surprise call for the election in April, the pound surged 3 cents to $1.29 on optimism that her Conservative Party would win convincingly, giving her a stronger hand in the upcoming Brexit discussions. That put the pound at its highest since early October, a level it has since held.

But since April, polls have shown the Conservative lead narrow sharply, raising questions about what the outcome might mean for the British economy and the Brexit talks, which are officially due to begin this month.

When she called the election, some pollsters had the Conservatives a whopping 20 percentage points ahead of the main opposition Labour Party, which would have handed May a majority of more than 100 seats in the House of Commons.

Pollsters differ over the extent of the narrowing in the lead. According to most, the Conservatives are still headed for a solid victory of about 50 seats, while some say there's a chance of a so-called hung parliament in which no one party gains a majority and has to cobble together support from other parties to get over the line.

When the exit poll is published when the voting booths close at 10 p.m. local time Thursday, traders in Asia will be the first to see the effects — as they were for the Brexit vote in June last year, which saw the currency slide around 10 percent.

Asian traders were also in the front line on Oct. 7, 2016 when the pound tumbled to 31-year lows against the dollar after a "flash crash," the cause of which has not been properly determined. By contrast, on Jan. 17, the pound enjoyed its biggest one-day rise against the dollar in nearly two decades after May outlined her Brexit strategy and promised lawmakers a vote on the final deal.

"As has been highlighted on a number of occasions over the past twelve months, the pound can see sharp moves develop very quickly," said Simon Derrick, chief markets strategist at BNY Mellon.

Traders are preparing for all potential outcomes, from a landslide victory for the Conservatives to a hung parliament that may involve days of horse-trading between political parties, or even the establishment of a minority Labour government.

Currency strategists ascribe varying risks to the potential outcomes.

Most appear to think that a convincing victory for May would provide political certainty for the next five years, giving her a freer hand in the Brexit negotiations to make the compromises necessary for a deal. She would, the reasoning goes, be able resist calls from some in her party who are prepared to see Britain leave without any sort of trade deal that would provide business easy and cheap access to the EU single market.

Conversely, should the Conservatives remain in government but with a small majority, May could struggle to unite her party for the Brexit talks. That would increase the risk that Britain could leave the EU without access to the EU market or some kind of a new trade relationship — meaning tariffs on its exports to what would then be the 27-country bloc. That prospect of a "hard Brexit" has worried businesses in Britain, and markets, as the EU is the biggest destination for British exports.

"If the Conservatives win, the size of their majority will determine how markets react," said Samuel Tombs, chief U.K. economist at Pantheon Macroeconomics.

Others think a minority Labour government may end up being positive for the pound following a short-term wobble as it could reduce the prospects of a "hard Brexit." The Labour party has indicated a greater desire to try to stay in the tariff-free EU single market, a stance that would find support from other parties, such as the Liberal Democrats and the Scottish National Party, in the House of Commons.

Whatever the outcome on Thursday, the pound's fortunes over the coming months, and even years, will likely track political developments related to Brexit.

"Even if this week's election leads to a lessening in near-term political risks, over the longer term, political factors will remain an important— and likely an increasingly important — influence for the British pound as the formal commencement of EU exit negotiations approaches," said Erik Nelson, currency strategist at Wells Fargo Securities.