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Is there a silver lining for the pound after the UK election?

Here’s what investors are watching as a new trading week beckons.

Will there be further losses for the pound or will soft Brexit hopes be a cushion?
A weak pound has been a constant feature of financial markets since the UK voted narrowly to leave the EU nearly a year ago. Sterling was duly punished on Friday after the UK election delivered a hung parliament, in which no party commands a majority. However, some in the currency market are asking whether there is a silver lining for sterling.

In practice this would be the Conservative government having to take a more conciliatory approach towards Brexit negotiations, putting access to the single market as the chief aim in the talks.

‘’The result increases the probability Britain will have to make greater compromises with the EU’’, which reduces the “chance of acute volatility”, says Mike Clements, head of European equities at SYZ Asset Management.

At about $1.27, the pound is close to where it was trading before Theresa May called the surprise election in April. In contrast, the pound remains notably weaker versus the euro since the election was announced.

Mark Burgess, chief investment officer at Columbia Threadneedle Investments says: ‘’It seems reasonable that any Brexit deal will now be subject to greater parliamentary scrutiny and the government is more likely to seek to retain some elements of single market access.’’

Mike Amey, head of sterling portfolio management for Pimco says: ‘’Looking ahead, assuming a base case of easier fiscal policy and a “softer” Brexit, we would expect higher yields, a steeper yield curve and stability returning to the pound.’’

Will the Federal Reserve dent or energise Treasuries?
A year ago, a looming UK vote on its membership of the EU was one of the reasons the Federal Reserve passed on lifting interest rates. Fast forward 12 months and officials at the US central bank are widely expected to raise short-term rates when they meet on Wednesday.

The prospect of the Fed adding a fourth rate rise to the current cycle has failed to dent a rally in Treasuries, which has sent the yield on the benchmark 10-year bond from 2.63 per cent in March to as low as 2.14 per cent last week.

With recent US economic data proving lacklustre, one of the questions facing investors is whether policymakers’ view on the economy has grown any more cautious. Any sign that it has is likely to give further impetus to the bond rally.

There will also be plenty of interest in whether the Fed chooses to elaborate its strategy for unwinding the $4.4tn balance sheet it built up from its bond buying. Economists at Morgan Stanley expect that after next week’s meeting, the Fed’s focus will turn to its balance sheet.

“We expect the Fed to pause on hiking rates at the September meeting, instead announcing that it will begin a gradual and predictable drawdown of its balance sheet starting in October, then resume the gradual pace of hikes at the December meeting.”

Will the EU relocate euro clearing from London to the continent?
It could be a pivotal day for the City’s post-Brexit future on Tuesday, when Brussels reveals its proposals to police the $850bn a day over-the-counter euro-denominated derivatives that are cleared in London.

The industry’s future has become an early Brexit battleground because London processes around three-quarters of the euro market for swaps, which companies and investors use to manage their interest risk exposure. Following the Brexit vote, the EU wants greater control to intervene in during times of market stress and is concerned it could be powerless once the UK is outside its jurisdiction.

The debate is a great concern for banks because of the more than $80bn in margin they provide clearing houses to backstop derivative trades. Most would rather keep clearing of euro-denominated derivatives in London because they can concentrate their portfolios in fewer places, and net down their exposures and thereby save billions of dollars in collateral and associated capital charges each year.

One option the European Commission is assessing is forced relocation of euro derivatives into the EU, which would split the pool of capital and raise margin costs. One UK data group estimates costs could nearly double, to $160bn. Deutsche Börse, which stands to win from such a policy, calls the number unrealistic. The Brussels paper could go a long way to putting investors’ minds at rest, kick off a concerted lobbying effort or begin an industry debate exploring ways to cope with the changes.