The latest in a string of sensational political upsets to roil Western democracies has left the U.K.'s Conservative Prime Minister Theresa May clinging to power thanks to the support of a small Northern Irish party instead of boosting her parliamentary support as she had hoped. While market reaction, including the sharpest fall in the pound in eight months, has been tempered by hopes for a softer Brexit, she must now hold together a fragile majority as she tries to strike a deal on leaving the European Union with a hard-bargaining Brussels.
The Conservatives fell short of an overall majority in the June 8 election, losing 12 seats. The party secured 318 seats in the 650-seat parliament, with one constituency left to report, but indications June 9 that Northern Ireland's Democratic Unionist Party, with 10 seats, would support them allowed May to visit the Queen to receive assent to form a government.
While the DUP is pro-Brexit, it is opposed to the installation of passport controls on the border with the Republic of Ireland. Investors calculate this might lead May to soften her line in the exit talks, reducing the chance that the U.K. could walk away with no trade deal at all and increasing the possibility of an arrangement like that enjoyed by Norway, which has access to Europe's internal market in return for abiding by EU rules. On the other hand, May's hopes when she called a snap election in April of boosting her majority in order to give her more negotiating leeway by allowing her to ignore the more strident euroskeptic voices within her own party, have now been dashed.
"Political uncertainty has increased: the British negotiators will head to Brussels for talks due to begin June 19 without a clear agenda as consensus within parliament regarding the type of Brexit remains elusive," Barclays analysts Fabrice Montagne and Andrzej Szczepaniak wrote in a note, adding that it was premature to identify any other effect of the elections on the talks other than to inject additional uncertainty.
Brexit: Harder or Softer?
"It is still too early to say whether the outcome of the election would alter the probability of an orderly hard versus an orderly soft Brexit. In practice, slim majorities tend to water down policies as the government is not able to take strong positions," they said, adding that pro-government MPs might continue to support calls by May for exiting the European Court of Justice and cutting immigration which are incompatible with continued access to the single market.
The pound tumbled 1.7% against the dollar to $1.2742 at 8:44 a.m. ET, retracing earlier losses of as much as 2.3% in its worst trading day since October. London's FTSE 100 stock index, many of whose companies have foreign earnings, jumped 0.5%.
The currency has sunk from over $1.40 since last June's referendum vote to leave the EU, which proved to be the first of a series of global political developments which seemed to turn long accepted wisdom on its head, including Donald Trump's victory in the U.S. presidential race and the election of Emmanuel Macron in France at the head of a completely new political movement.
The pound's fall was broken as investors bet that the DUP's hopes for a soft Irish border might push May toward a softer Brexit, Nomura currency strategist Jordan Rochester said. Pro-Brexit Conservative MPs might now also moderate their positions, he added.
"I think they'll be doing a bit of soul searching, because if they don’t sort out their core message then whenever the next election is, it might not be them in No. 10," he said, referring to No. 10 Downing Street, the official residency of the prime minister.
Pound Fall Limited
Some strategists were surprised that the pound did not fall more on the loss of the Conservative majority, Rabobank currency strategist Jane Foley said.
"Whether Theresa May is prime minister or not, if the Tory party is forced to rely on non-Tory votes, the market is beginning to think that parliament is going to be a little bit softer on Brexit and that therefore she might have to make some compromises," she said, adding that if Conservative rivals try to displace the prime minister as punishment for her poor election campaign then the market will evaluate them according to their position on Brexit.
Any candidates such as Foreign Secretary Boris Johnson, or David Davis, secretary of state for exiting the European Union, would be seen negatively, due to their euroskeptic views, Foley said, while someone like Home Secretary Amber Rudd, seen as more moderate, would be welcomed by investors.
Senior Conservative voices including former minister Anna Soubry and former finance minister George Osborne have already said May should consider stepping down.
The European Union's budget commissioner Guenther Oettinger told German radio he was unsure if Brexit negotiations could begin on time, adding that a weak negotiating partner could result in a poor outcome for all sides.
Polls on the eve of the elections had predicted a Conservative lead of between 13 and 1 percentage points. The Labour Party, led by left-winger Jeremy Corbyn, added 31 seats to 261, in a result which made a nonsense of pundits' predictions after a campaign in which he appealed to young people with promises to abolish university tuition fees, re-nationalize major infrastructure and boost taxes on corporations and high earners. The result consolidated the control over the main opposition by Corbyn, for long a marginal figure within his own party but whose rise echoes support for fellow left-wing insurgents like Bernie Sanders in the U.S. and Jean-Luc Mélenchon in France.
While the election result may have unpredictable consequences for the U.K.'s relationship with the EU, it did however reduce one other key source of political uncertainty. The Scottish National Party lost more than a third of its seats, taking its total to 35 and sapping momentum toward another referendum on independence for Scotland.