Sterling firmed on Wednesday after two days of losses to touch three-week highs versus the euro but options markets signalled pain ahead, betting on a greater risk of a no-deal Brexit under Britain's new leader Boris Johnson as economic stress worsens. Johnson took office as prime minister vowing to implement the result of the 2016 Brexit referendum and lead Britain out of the European Union on Oct. 31 with "no ifs or buts".
That could pitch the country into a showdown with the EU and trigger a constitutional crisis at home, as many lawmakers have pledged to bring down any government that tries to force a no-deal Brexit.
UK economic data has also been dismal in recent months, with a recession seen likely. But the pound strengthened as much as half a percent on Wednesday against the dollar and rose to a three-week high versus the euro as traders cut some extreme short bets against the British currency.
Jordan Rochester, a strategist at Nomura, said the pound's move was a classic "buy the rumor and sell the fact" price action with investors trimming some of their net short positions in sterling expected to be around $6 billion. Claire Dissaux, head of global economics and strategy at Millennium Global Investments, said Johnson would likely end up with a hard Brexit via a 'Canada-plus' type of trade agreement, which would be negative for the economy and the pound.
"Even with the prospect of some fiscal stimulus which has been promised by Johnson, you do have a big cyclical downturn which is (becoming) structural," Dissaux said, noting a widening balance of payments gap, declining investment, and signs of economic contraction. "Plus you have the Bank of England which is turning dovish."
Sterling stands less than half a percent off the 27-month low it hit recently against the dollar. It jumped 0.5% at $1.2495. Against the euro, it also rose 0.5% as the single currency weakened to three-week low. In the currency derivative markets, volatility gauges remain elevated, with three- and six-month implied volatility at the highest since April.
Investors are also increasing their bias for sterling puts over calls in the three- and six-month sterling-dollar risk-reversals market, with the three-month bias the greatest since April. Puts confer the right to sell at a pre-agreed price while calls allow a holder to buy. ING analysts said Johnson faced a battle with a divided parliament over the no-deal scenario.
"A general election is increasingly likely - maybe even inevitable. This suggests a softer pound, meaning that any sterling strength should be faded in our view," they told clients, predicting the currency would approach 0.95 pence per euro and fall below $1.20 to the dollar. However, the risk of a no-deal Brexit is still considered to be below 50%, and options do not seem to be fully pricing a no-deal scenario, with implied volatility well below the levels of before the original March 31 Brexit deadline.
Many reckon sterling moves will be contained until there is greater clarity on Brexit, given the currency has fallen over 6% since May versus the dollar and parliament starts its summer recess on Thursday.
Fahad Kamal, chief market strategist at Kleinwort Hambros, expects Johnson to adopt a pragmatic stance on Brexit once in office, allowing sterling "a slow grind upwards." "Regardless of politics, sterling has been reliably mean-reverting over the past 50 years and it's very cheap ... whether in terms of purchasing power or in real terms." Trade-weighted sterling is near its lowest since 2017.
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