Why short-term sterling euphoria could turn into long-term gloom

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The British pound   GBPUSD, +0.2283%  edged up to its highest levels since May on Tuesday, after jumping 2% since the beginning of the month on the prospect of a Conservative party parliamentary majority in the U.K. elections on Thursday.

A Tory majority would avoid a repeat of the hung Parliament of recent years in which the House of Commons, the UK’s main legislative body, was unable to decide which form of Brexit it favored, if any.

Meanwhile the current polls probably exclude the possibility that the Labour party will obtain the majority that would enable it to implement its platform of nationalization of major industries, along with higher taxes and higher government spending.

Voters in the UK have thumbed their noses at pollsters in every national election since 2010, so it would be foolish to rule out a December surprise this year, but even assuming the Conservatives indeed return to Parliament with a comfortable majority, the pound will remain fragile at least throughout next year.

Brexit won’t be “done” on January 31, as Conservative party leader and Prime Minister Boris Johnson has claimed during the election campaign. It will only start. A year long transition period will follow with little changing initially, but with the need to hastily negotiate a free trade deal with the EU in that time.

The possibility of a “hard” Brexit still looms though if Johnson confirms his intentions to only sign a barebones free trade treaty with the EU. As Ivan Rogers, the former UK envoy to the EU, has noted, this would be hugely in Brussels’ interests. It would concern only goods and leave aside the services sector which is of utmost significance for the UK economy.

In other words, uncertainty will prevail for financial markets throughout the first half of next year and the deadline to request an extension of the transition period is July 1.

And the type of deal with the EU envisioned by the Conservative party is “one of the hardest (most economically costly) versions of Brexit,” as noted by Bank of America analysts.

In the coming months, markets will have to live through the same kind of uncertainty they suffered in 2019. Furthermore, if the Bank of England starts worrying about the recessionary impact of Brexit, it may lower interest rates, which would weaken the pound further.

After climbing from a three year low seen in August, and rallying to a seven month high his week, the pound GBPUSD, +0.2283%  is still 8% below the level it had reached before the Brexit referendum in June, 2016.

It’s hard to see how it would climb back to those levels anytime soon.