How does the UK general election affect the pound? Traders are second-guessing where sterling is headed before the nation goes to the polls again on June 8th as politics seem to remain front and centre in the forex markets.

Snap judgment

The surprise move by Theresa May to call an early election came on April 18th. The snap judgment from the markets was to see this as positive for sterling. The pound jumped by the most in three months – since May set out her vision for Brexit in January – and is now trading in the $1.28-$1.20 region.

It does seem that sterling likes the certainty of May’s clean Brexit approach, even if it might also equate to a hard Brexit. The gains this year for sterling that coincide with decisive moves by Mrs May do smack of the market preferring this ‘clean, hard’ Brexit to a messy one.

Polls

There are perhaps three big reasons why the vote itself has delivered a stronger pound, and this depends on what the polls are telling us.

First, by calling an election early the government, of whatever hue, gets extra breathing space. With the exit due to be completed by 2019 an election in 2020 was always going to be tough and potentially messy. By going to the polls now the government won’t have to face another election until 2022, giving it a lot more time to hammer out the transition deal.

Second, based on the polls we have to assume that the current Conservative majority will be larger. This would appear to weaken the hand of the hardliner Brexiteers in her party and make a smoother transition out of the EU easier. This might be a little bit optimistic but we will see.

Thirdly, if May comes into the negotiations proper with a stronger mandate from the electorate, she may be in a better position to get the UK a better deal.

Clearly at $1.20 sterling was stretched to the downside and has been looking for any reason to rebalance a bit. The feeling is that at that level the worst of the Brexit was priced in.

Risks

There are risks to this consensus. If Mrs May fails to get the thumping majority she is hopes for, her position could look less secure than before she called the snap election. This risks throwing open a Tory leadership contest and the prospect of a hardline Brexiteer in charge.

Then there is great unknown that is the Brexit negotiation itself. This is uncharted territory for politicians and for markets. Things could in either direction without too much warning. It’s worth remembering that the decline in sterling is based on an expected change in trading relationships and resultant requirement for a rebalancing of the exchange rate.

Bank of England

For the pound, this election is all about Brexit. And the Bank of England is paying attention. At its recent May meeting the Bank’s Monetary Policy Committee (MPC) included a specific reference to growth and inflation projections being contingent on a smooth Brexit.

Sterling cratered below the $1.29 level after we got none of the hawkishness from the Bank of England that pound bulls had been pinning their hopes on. For all the talk that Michael Saunders might follow Kristin Forbes the Bank was not that hawkish. Some pound positioning seems to have been based on a more hawkish Bank after chatter on the street that Saunders would vote for a hike after his speech in April and this contributed to a pretty sharp fall in cable, which is now stabilising around $1.288.

Overall the forecasts are not a lot different from February. The Bank seems to think there will be a bit extra inflation this year and a bit less growth as price growth crimps consumer spending. Those soggy Q1 numbers clearly made an impact on policymakers. Weak trade balance and industrial numbers also indicate that the UK economy is beginning to falter. Combine those with the Q1 growth numbers and there is a sense that while resilient, the economy resembles a slowly deflating balloon.

But then looking out to 2018 we’ll see inflation moderate and growth pick up. Inflation is likely to peak just shy of 3% at the end of the year before easing back as the main impact of the slump in sterling exits the year-on-year calculations. Policymakers again signalled they are happy to look through the transitory impact on prices of the weak pound. The fact is this inflation is not demand driven so the Bank can afford to ignore it and focus on supporting the economy through a tough patch.

Meanwhile there was some positive language around trade, exports and pay, with the MPC noting that given low levels of unemployment, “wage growth is expected to recover significantly”.

But, and it’s a very big but, the Bank’s forecasts are predicated on a ‘smooth’ Brexit. With an election around the corner this is a clear message to the incoming government that working out a good deal with the EU is essential to future growth prospects.

The question is when a hike might come. There is a slight tightening bias as the MPC said that if the economy follows its May projections then monetary policy might need to be tightened faster than the current yield curve in the market implies.

A catalyst for a hike therefore might come from more robust consumer spending, particularly if wage growth really does pick up faster than we are seeing now. If this surprises to the upside over the rest of the year it could see growth exceed the Bank’s forecasts and this may let the hawks take a grip.

Another catalyst might be the election, but we’ll need to wait until June 9th to find out just what the effect on forex markets is.