Mini panic over May unlikely to have lasting impact on the pound

The pound has dropped 1% so far today, and is back below the $1.31 level after a report in the Sunday Times argued that 40 MPs are now willing to vote against Theresa May stoking fears of a leadership challenge before year end. We have known that Theresa May’s position as Prime Minister is tenuous after her failed gamble in this year’s election. However, she still won the most seats compared to any other leader, and it remains unclear who would be a successful challenger in the Conservative Party considering the cabinet, from the outside, looks like a den of iniquity.

The perils of unsubstantiated stories…

However, even though a leadership challenge doesn’t appear a realistic option right now, the souring of the political outlook in recent days -  Theresa May has lost two members of her cabinet in as many weeks - has jolted investors out of their Autumnal slumber. 1-month GBP/USD volatility had sunk to its lowest level since May last week, but it has since risen sharply, as we can see in chart 1. This tells us something about market psychology: when markets get too complacent, unsubstantiated stories can trigger a bout of volatility and a rush to the exits.

It is worth putting this move into context: GBP/USD is still trading within November ranges. If this story has legs and we see a potential ousting of May by her own party, then we would expect the pound to fall further. However, if this story quietly goes away and Tory MP’s keep a lid on their bubbling frustrations with the PM, then we could see 1.3040 – the low from 3^rd November, act as key support. Even 1-month volatility for GBP/USD is only back at early November highs around the 8.00 level, this is below the mid-October high when volatility peaked at 9.0.  

Beware complacency regarding the pound

So, what does this mean for the pound? Firstly, today’s move tells us that the markets are on alert for political risks emanating out of the UK, and if there is a party coup to replace Theresa May then political turbulence is likely to weigh on the pound further. Secondly, even though the pound has had a jolty start to the week, volatility and technical signals do not suggest to us that the pound is about to fall off a cliff just yet, we may need this story to develop further to get another big move lower in sterling. Thirdly, don’t get too complacent about the pound, the political and Brexit situations remain fluid and can throw up surprises. In future, when volatility is low in the pound investors should be on their guard that a pullback is likely.

On the bright side, a weak pound has been good for the FTSE 100 so far, which is leading the European stock indices higher at the start of this week, although it has not been so good for the FTSE 250, which is down 0.6% so far, as the smaller UK index is more UK focused and thus sensitive to political risks.

Chart 1:

Source: City Index and Bloomberg