by Simon Derrick
With the United Kingdom enjoying another summer of political unease, it’s worth considering what the defenestration of Boris Johnson as leader of the Conservative and Unionist Party might mean for Sterling over the medium term.
How has Sterling reacted to the PM’s resignation?
The pound managed to stage a rally against the Euro following the reports that Boris Johnson was to step down as head of the Conservative and Unionist party and has held on to these gains in the days since then. While it’s possible to construct a complex argument as to why this happened, the most likely answer is investors felt a sense of relief that an increasingly unpopular PM was now getting ready to leave. More specifically, with Labour’s lead in the polls widening since the start of July, the sentiment was that a change of leadership might provide the Conservatives with some chance at the next election rather than no chance at all.
It’s worth noting that this is not a reflection on the economic competency (or otherwise) of a potential Labour or coalition administration. Neither is it a comment on how Sterling would perform under such a government. Instead, it is simply a note on how the pound has performed before ahead of elections when Labour has been doing well in the polls. Of course, the one thing that truly unsettles the currency ahead of and during an election is uncertainty. This most obviously emerged during the 2010 general election when a week of turmoil following the result saw the Pound come under increasing pressure.
The King is dead, long live the King or Queen
So, who is likely to succeed Boris Johnson as head of his party and as Prime Minister?
At present (the morning of July 12th) the bookmakers have Rishi Sunak, Penny Mordaunt, and Liz Truss as the front runners. However, there are reasons to be cautious in this case about reading too much into the “wisdom of crowds.” Firstly, these numbers reflect betting from the UK population as a whole rather than just members of the Conservative Party, the people that will make the final choice between two candidates during the second stage of voting. Secondly, it is worth recalling that weight of money can have a significant bearing on such betting.
Possibly a more accurate measure comes from the Conservative Home website (a blog that supports but is independent of the Conservative party). Here polling from the start of this week shows Penny Mordaunt and Kemi Badenoch as the two leaders, significantly ahead of former Chancellor Rishi Sunak.
It should also be said that favourites in Conservative party leadership contests often don’t win. With this in mind it is worth noting that Stephen Bush in the FT has made a cogent case for the final run off to be between Liz Truss and Rishi Sunak.
So why does this matter
A poll by JL Partners conducted on the 6th and 7th of July asked members of the public to choose between Labour leader Sir Kier Starmer and a number of prospective leaders of the Conservative party. Of these Rishi Sunak was the only one to come out ahead. Subsequent surveys by Opinium and YouGov produced similar results.
These are just three polls, and the next general election may not take place until January 24, 2025. Nevertheless, with Labour well ahead already and a fresh burst of energy price inflation set for later this year, the pressure will be very much on the new leader to formulate aggressive populist fiscal policies in order to reverse this potential trend.
Unfortunately, this is exactly the opposite of what the Office for Budget Responsibility is calling for right now, arguing that tax rises or spending cuts are required to avoid an “unsustainable” public debt burden. Moreover, the risk is that an aggressive spending programme allied to tax cuts over the months ahead could further feed into inflation, forcing the BOE to hike even more aggressively. This, in turn, would only increase the threat to the UK housing market at a time when prices already look dangerously inflated.
With little to say that public thinking on Brexit has changed materially since 2016 there may also be a temptation for the new leader to continue a hard-line approach towards Europe. Indeed, this seems pretty well what those in Brussels see as the most likely outcome.
So what?
A solid Labour lead in the polls, a dearth of Conservative leadership candidates seen as capable of beating the current head of the Labour Party, rising inflation, the risk of an unaffordable fiscal approach and a continued hard line on Europe hardly add up to a Sterling friendly package. The question therefore is why the Pound hasn’t already moved? Forget the moves against the Dollar, they are rather more global in nature.
The first thing to note is that Sterling has been relatively stable against the Euro since 2016. Putting aside the periodic crises that came along on both sides of the Channel during this period, the most likely explanation for this was the very modest yield pick up available in the UK. However, if this is true then an alarm bell should be ringing about the Pound’s performance this year. Despite a 100 bp hike in the BOE’s bank rate this year, Sterling weakened steadily through the spring and early summer of this year, only reversing as it became clear the PM’s position was becoming untenable.
It therefore seems reasonable to say that politics and the outlook for the economy have quietly become a major driving force for the currency in 2022. Hence, while relief that the current PM is finally leaving No 10 is reflected in the current rally, the outlook beyond here is significantly confused by uncertainty over the potential outcome of the Conservative Party leadership race.
And Finally
Sterling volatility has demonstrated a reasonable degree of seasonality over the years with late July and August often proving quiet, reflecting both the Parliamentary recess and the vacation period in financial markets. It therefore wouldn’t be surprising were this pattern to repeat itself this year. However, this might prove the calm before a stormy autumn. Much will depend on that leadership contest. Should the new party leader (set to be chosen by the start of September) veer towards a more populist fiscal policy then Sterling could come under increased pressure throughout the autumn and winter.