LONDON: Sterling languished just off four-month lows on Tuesday, with the outcome of last week's European election seen possibly emboldening proponents of a no-deal Brexit as the battle to succeed Prime Minister Theresa May got underway.
The prospect of a no-deal Brexit, which most economists say would severely damage the British economy, re-emerged as a key risk for sterling after May said last week she would step down as leader of the Conservative Party on June 7.
With the Brexit Party handing the ruling Conservatives a drubbing in last week's European elections, many Conservative candidates vying for May's job are under pressure to deliver a more decisive break with the EU when Britain is scheduled to leave the bloc on Oct. 31.
While foreign minister Jeremy Hunt said no-deal Brexit would amount to "political suicide", other candidates including front-runner Boris Johnson have signalled they are prepared for that if Brussels does not reopen negotiations over May's unpopular withdrawal agreement.
However, sterling's downside was limited by the fact that parties opposing Brexit also made sharp gains in the vote.
The British currency slipped 0.13pc to $1.2657, having traded as low as $1.2605 last week.
It was down 0.2pc versus the euro at 88.405 pence to stand just off four-month lows .
"For the Brexit Party to get so many votes is a sign to politicians that people are not as afraid of the no-deal scenario as most members of parliament. So the no-deal risk has increased a bit," said Morten Lund, FX strategist at Nordea.
But no-deal Brexit probabilities remain around 15-20pc, according to Lund, who expects lawmakers to call a no-confidence vote against any prime minister who chooses that route.
"It's more or less priced in that Boris Johnson will become prime minister, so with the pricing now I don't see that much downside. I see sterling trading around these levels but with a downward bias," he said.
BREXIT COMPROMISE
The pound has fallen for three consecutive weeks versus the dollar and euro.
It has lost 3pc this month as May failed in her effort to find a Brexit compromise with the opposition Labour Party and then announced she was stepping down.
Many analysts noted, however, that the election had also rewarded the Liberal Democrat and Green parties, which have steadfastly opposed Brexit and want another referendum which could reverse the June 2016 vote to leave the EU.
The increased support for these groups as well as for the Brexit party came at the expense of the two main parties and could imply a rising probability of a second referendum if a deal cannot be reached by whoever succeeds May.
Esty Dwek, Chief Market Strategist at Dynamic Solutions, the research arm of Natixis Investment Managers, noted that while UK voting levels had been low, "remainers did better from voters who actually showed up.
This might increase chances of a second referendum, but this isn't our base case scenario for now".
"Sterling hasn't benefited, given the uncertainty with Brexit remains centred around Mrs May's successor," she added.
Options markets are indicating increasing jitters about the Oct. 31 deadline, with implied volatility contracts expiring after that date trading at a significant premium to those expiring earlier.
The premium for sterling puts -- the right to sell at a certain price -- has also risen compared to calls which confer the right to buy.
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