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There’s only one type of Brexit investors are braced for

Until this week, markets were not expecting the UK election to offer any twists, let alone a shock redolent of last summer’s Brexit vote.

Signs of a tighter race between the country’s two major parties has been a reminder of the febrile nature of the currency market, with the pound afflicted by volatile trading on Wednesday after a controversial modelling of the result by the pollster YouGov highlighted the possibility of a hung parliament.

True to the post-EU referendum playbook, equity markets seized on sterling’s weakness with the FTSE 100 climbing to a new intraday record.

The chances of a hung parliament when the votes are counted on June 8, or a reduced majority for the Conservatives from their current 16-seat advantage, remain outliers. Sure enough the midweek swoon in the pound faded once traders looked at other polls showing Theresa May’s government remains on course for an enlarged majority.

What should trouble investors — and a point being flagged by the government bond, or gilts, market — is that this has been an election campaign marked by little discussion of, let alone answers to, the economic challenges facing the UK in a world beyond the EU.

As Alberto Gallo at hedge fund Algebris says: ‘’We still don’t see policies that deal with the consequences of Brexit and help adjust the economy, such as boosting long-term productivity.’’

Just as alarming are the growing doubts about the negotiating prowess of Mrs May after a series of policy U-turns and a lacklustre performance on the hustings.

The pound’s rise above $1.30 last month came at the peak of polling prowess for the Conservatives, with the party commanding a 20-point lead. The currency’s slip below $1.28 this week, and on a trade-weighted basis to its early-April low, is the first chink in the currency market’s strong mandate trade.

Marc Chandler, strategist at Brown Brothers Harriman, says a legacy of the current election may be the appearance of a weaker leader that could haunt Mrs May’s term. This has prompted a surge in currency hedging in recent days he says, with a sharp rise in the cost of put options, an insurance position that becomes profitable should the pound fall sharply in the coming months.

Chris Watling of Longview Economics, says the market wants a strong mandate for Mrs May to negotiate Brexit. A less clear-cut victory only compounds the uncertainty over how the UK will leave the EU as the clock ticks down to March 2019.

Investors are mindful that the sorry episode of Greece remaining deeply indebted and in no realistic position to ease such a straitjacket serves as a blunt warning for the UK; negotiating a divorce from the EU will be very hard.

As it stands, the two-year gilt yield, which takes us just beyond that first-quarter deadline in 2019, illustrates the degree of apprehension about the future. It is in contrast with high-flying equities and currency bulls expecting a stronger rebound for the pound by the end of 2017.

Currently yielding around 0.10 per cent, the two-year gilt sits below the current overnight rate of 0.25 per cent set by the Bank of England. The inversion between the base rate and two-year gilt yield has largely prevailed since the Brexit vote.

This downward kink in the yield curve suggests bond traders think a hard Brexit or no deal within the next two years is likely and it will hammer the economy hard. This gloomy view is echoed by the 10-year gilt, whose yield this week briefly dipped below 1 per cent — a level last seen in October. Gillts have been outperforming both US Treasuries and German Bunds, suggesting that the UK economy’s prospects versus those countries are weakening.

Critically, record low interest rates and easy credit have helped keep the British consumer going, with retail sales bouncing back in April. That has helped offset the higher inflation that comes via a weaker pound, but a record level of outstanding debt on credit cards is the ominous bill awaiting payment.

And the uncertainty surrounding the Brexit negotiations continues to drive a sharp divergence between the share price performance of UK companies that are international and those whose fortunes are tied to the health of the domestic economy.

KPMG’s index of 50 UK companies that earn at least 70 per cent of their revenue in sterling, briefly turned positive for the first time since the Brexit vote. In recent days, however the index has slipped back, while KMPG’s Non-UK 50 index of companies generating 70 per cent of their earnings abroad, is nearly 30 per cent higher since the referendum.

A two-year gilt yield near zero, buying protection against a much weaker pound, while owning UK companies reliant on foreign revenues tell us that investors are preparing for a hard Brexit.

michael.mackenzie@ft.com

John Authers is away