A hung Parliament. Sterling plunges. What would come next?

The Conservative party poll lead ahead of today’s General Election has narrowed dramatically, with some pollsters even predicting a diminished majority for the Tories – or even a hung Parliament.

The latter is the nightmare scenario for investors: if the Ipsos Mori exit poll at 10pm shows no overall majority for any of the parties expect an immediate big fall for sterling.

“Initially the market would take it negatively,” says Lee Hardman, a currency analyst at MUFG. The massive uncertainty would hit the currency, and there would be “huge uncertainty as well on the next government’s Brexit strategy”, which has been by far the most important driver of sterling’s fortunes against other major currencies over the last year.

But what happens after that? If no parties have a working majority (of more than 323 out of 650 seats, depending on the fortunes of Sinn Fein) then it all goes down to the murky world of backroom deals in the proverbial smoke-filled rooms.

Here are some of the possible scenarios.

A new Tory coalition (but possibly not under May)

It should be emphasised a hung Parliament is still unlikely: the last polling average by Britain Elects shows the Conservatives at 43.7 per cent of the vote, which would beat Margaret Thatcher’s landslide majority in 1983.

So the most likely scenario in a hung Parliament is that Conservative leader Theresa May falls just short of a majority.

In 2010 this was resolved in relatively smooth fashion (at least in hindsight) as the Nick Clegg-led Liberal Democrats joined David Cameron’s Tories for a strong coalition majority. This time around things are more complicated, with the Lib Dems ruling out another coalition.

If the Conservatives are only a handful of seats short they could theoretically look to other small parties. Time for Northern Ireland’s unionists to step up.

The Democratic Unionist party (DUP) and the Ulster Unionist party (UUP) share the broad economic outlook of the Conservatives, while both are strongly in favour of the UK staying together and will probably hold around 10 seats.

Most importantly, though, the larger DUP (which had a champagne reception at the Tory conference) is staunchly behind leaving the EU, and would likely support the “hard Brexit” favoured by the right wing of the Tories.

The prospect of a harder Brexit (owing to a slim working majority) could lead to sterling falling back to around the middle of the range hit since May announced the election in April, according to Martin Arnold, foreign exchange strategist at ETF Securities.

“The worst-case scenario [on a Brexit deal] has already been priced in,” he says. “I don’t think it will unwind the whole way, but it will drop.”

Yet intense pressure on May would also be added to the mix. She would “undoubtedly” step down, according to BMI Research – an outcome which would add another (almost certainly negative) dimension for traders to take into account.

Corbyn enters the fray

A hung Parliament would represent a triumph for Corbyn (if not for a Labour party which has won three General Elections in the last two decades). If the Tories fail to form a government it will be Labour’s turn to try.

The last time the UK electorate failed to deliver a clear answer currency markets were roiled. This time, with Brexit hanging over everything, that volatility could be even rougher.

The Lib Dems and the Scottish National party (SNP) have ruled out a formal coalition with Labour, but Corbyn could theoretically form a minority government, passing bills with whatever support he can muster.

A “confidence and supply” arrangement would see a minority government able to get through votes of no confidence and Budgets (likely with big concessions), but could lead to a very unstable government.

Vote by vote

The implications of a minority government on the Brexit negotiations would be up for endless debate – for investors trying to guess the next step and for the politicians trying to actually take it.

Labour’s manifesto says it wants to retain “the benefits of the Single Market and the Customs Union” while controlling immigration – meaning the “soft Brexit” ideal of staying members of the EU’s tariff- and obstacle-free Single Market is off the table.

The Liberal Democrats are holding on to the idea that another referendum could overturn the Brexit vote, but the party has seemingly moderated its stance to staying in the Single Market, after it found it difficult to motivate “Remainers”.

That means the prospects for better trade access to the Single Market for British businesses, which is generally considered to be positive for sterling, are difficult to judge in the case of a minority Labour government.

Kallum Pickering, senior UK economist at Berenberg bank, says: “If a hung parliament forced a cross-party compromise it could lead to a softer Brexit strategy, and may turn out to be positive in the long run after some serious initial confusion.”

“I don’t think it would mean a soft Brexit,” says Paul Hollingsworth, an economist at Capital Economics, “but it could be that EU leaders look at it a bit more favourably.”

Can it last?

Yet one of the biggest questions for a minority government is how long it can last. A government which has to muster support for every individual vote is constantly under threat of collapse.

“As soon as it comes down to Brexit, does a confidence and supply agreement actually do anything?” asks Jeremy Cook, chief economist at payments firm World First. “I think we would see a minority government tear itself apart pretty quickly.”

Either way, a hung Parliament is still the worst-case scenario for sterling in the short term.

Berenberg’s Pickering says: “All hell could break loose metaphorically speaking, at least at first. The near-term uncertainty could be worse than it was after the Brexit vote.”

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