Sterling slips off 5-1/2-month high

Sterling pulled back from 5-1/2-month highs on Tuesday as markets priced in some uncertainty before crucial parliament votes on the government's Brexit withdrawal bill that will determine whether Britain can leave the European Union on October 31. It had earlier slipped as much as 0.5% after the BBC quoted a government source as saying the UK government planned to abandon Brexit legislation and hold an election by Christmas if parliament voted against the motion to rush the Brexit bill through in three days.

UK Prime Minister Boris Johnson then echoed this ultimatum to lawmakers when opening a debate before the vote. Having touched the day's low of $1.2889, the pound then recovered to around $1.2953. Versus the euro, sterling was little changed at 86.11 pence. "(The BBC report) has made the market wary that it could see an increase in uncertainty if we head towards an election," Lee Hardman, a strategist at MUFG, said. He described it as a knee-jerk reaction, given the pound's recent sharp rally.

The prime minister would need to win a vote to trigger an early election because one is not scheduled until 2022. That looks unlikely given he lacks a majority in the House of Commons. Lawmakers will vote at about 1800 GMT on the so-called Second Reading of Johnson's Withdrawal Agreement Bill, and then on the government's tight timetable for approving the legislation, also known as the "programme motion."

Defeat in either vote would scupper Johnson's plans to leave the EU on October 31. He is legally required under the Benn Act to accept any Brexit delay offered by the EU. "For cable to break and sustain a level above $1.30, the bill needs to go safely through parliament. If there are any complications that'll dampen the potential of the pound to strengthen much further," MUFG's Hardman said.

Markets now see the possibility of leaving without a deal as unlikely and that has boosted the pound about 6% since October 10, lifting it to 5-1/2-month highs of $1.3012 on Monday. Both the pound and British government bond yields have been lifted by fading expectations of interest rate cuts by the Bank of England.

Money markets now see only around a 60% chance of a 25 basis-point cut in December 2020. They had been fully pricing in a 25 basis-point cut next May as recently as October 10, when Johnson made his Brexit breakthrough during a meeting with the Irish prime minister. As the risk of a no-deal Brexit has faded, sterling implied volatility - the gauge of expected swings in a currency - has trended lower. But overnight implied volatility surged ahead of parliament's votes to 24.3%, the highest since January 2019.

Pound-dollar options expiring overnight lost little of their premium on Tuesday, suggesting that investors are still wary of moves in the pound after the votes. Britain's domestically focused FTSE 250 which has rallied in recent days, ended 0.64% lower, while 10-year Gilt yields dropped 10 basis points to 0.713% but partially retraced the move towards the end of the session.