“No deal is better than a bad deal” was Prime Minister Theresa May’s go-to phrase before the election result. She was talking about Brexit, but she now has another crucial set of negotiations clogging up her in-tray: a “confidence and supply” deal with the Democratic Unionist Party (DUP).
The hung Parliament in last week’s General Election has given the Northern Irish party more power in Westminster than at any point in their history, leaving traders nervously watching negotiations.
The conclusion of negotiations has reportedly been delayed until at least next week, according to the BBC. It's clear, however, that no deal is definitely not better than a bad deal for sterling in these particular negotiations.
By far the worst outcome for markets would be a collapse in the negotiations. Although that is not currently expected (with the DUP unlikely to throw away their huge, new-found power), the back-room dealings are likely to be intensive.
Any failure to reach a deal would weigh heavily on sterling. The pound fell sharply against the US dollar last Thursday evening as the exit poll revealed the hung Parliament, starting above $1.295 and plunging to below $1.265. Since then it has stabilised around $1.27 as investors hold back some judgements on further moves.
A collapse talks with the DUP would lead to another big downward leg for sterling, traders say.
“It would be a pretty sizeable injection of uncertainty,” said Edward Hardy, an economist at World First. "Markets are very sensitive to political developments at the moment."
Before Theresa May revealed the snap election the pound was worth around $1.25 – it jumped on the prospect of a strong majority for May to pursue Brexit negotiations. It would almost certainly return to those levels if negotiations collapse.
A “no deal” situation would also almost certainly bring about another hung Parliament – and leave the government’s Brexit direction hanging in the air as well, weighing further on the chances for the pound’s recovery.
A knee-jerk deal reaction
A “knee-jerk” upwards movement will likely greet a deal, as some of the huge unknowns start to become clear, according to Alexandra Russell-Oliver, currency markets analyst at Caxton FX.
“If we see a deal reached relatively quickly we would see some relief for the pound,” she said. “The longer this set of negotiations go on, the longer uncertainty is extended.”
Hardy agrees: sterling will jump "once we get a big headline about that formal deal between the Conservatives and the DUP."
But if a deal is reached investors will turn their attention back to Brexit, without doubt the most important matter facing the government and the UK economy.
Investors will be on tenterhooks to see if the deal explicitly addresses the Brexit approach, at least in what is made public.
The government has come under significant pressure to soften its stance on Brexit, with some business figures pushing for the UK to remain in the customs union, or even an push to remain in the Single Market.
The DUP’s thinking on this is clouded: its manifesto demands the UK stays in the customs union to avoid a hard border with the Republic of Ireland, which would almost certainly cause a massive hit to the Northern Irish economy. However, they have also campaigned vociferously for what most analysts consider to be a “hard Brexit” direction.
The next big trigger for sterling’s movement will be an indication of the government’s final position. A “no deal” with Europe could see sterling reach the 40-year-low levels seen in October, below $1.20 against the US dollar.
However, chances of a “soft Brexit” would massively improve the prospects for the currency, with investors likely to perceive a deal which preserves a high degree of access to the EU’s Single Market as positive for the British economy.
Richard Falkenhall, senior foreign exchange strategist at SEB bank, said: “If the British government softens its stance when negotiations with EU begin or if the chance of a constructive agreement on both terms of the UK’s exit and its future relationship with the Union were to increase for some reason, we would argue the pound would probably be too cheap against the euro and dollar at its present levels.”