LONDON (Reuters) - Sterling plunged to 28-month lows on Monday and headed for its biggest daily fall against the dollar since November as investors scrambled to factor in the risk of a no-deal Brexit and the possibility of a snap election.
A still-deeper fall in sterling remains on the cards; all metrics show that a disorderly British exit from the European Union is far from being fully priced in.
While most investors have until now bet on a last-minute agreement to avert a hard Brexit, that expectation is receding under new Prime Minister Boris Johnson.
“There is a realisation the market had not fully priced the increased chances of a no-deal Brexit,” said Claire Dissaux, head of global economics and strategy at Millennium Global Investments.
“The appointment of the cabinet (at the end of last week) showed that the default policy of this government is to leave with no deal,” she said.
Sterling losses accelerated after it breached a key psychological level of $1.23 and Johnson repeated that while he wanted to secure a new trade deal with the EU, the UK would exit the bloc on Oct. 31 with or without an agreement.
For a graphic on 'Pound at 22-month low', click: tmsnrt.rs/2ymejXu
By 1600 GMT it was down 1.3% at $1.2229 after hitting $1.2213 earlier, its lowest since March 2017. Against the euro, the pound touched 91.16 pence, its weakest since September 2017.
“All the stops are out and the pound is now in free fall,” Neil Wilson, an analyst at online brokerage Markets.com, said, adding the pound could tumble all the way to $1.21 if the $1.22 level was breached.
The British government said on Monday it assumed there would be a no-deal Brexit because a “stubborn” EU was refusing to renegotiate their divorce. Ireland called Johnson’s approach “unhelpful”.
The 27 other EU members have repeatedly said the divorce settlement is not up for negotiation.
Many investors say a no-deal Brexit could tip Britain’s economy into a recession.
Adding to the pound’s travails is the possibility of an early parliamentary election. The Conservative Party has risen in opinion polls since Johnson became leader, according to YouGov, which showed support for the party at 31%, well above the opposition Labour Party.
An election win could allow Johnson to overcome parliament’s opposition to a no-deal Brexit.
For a graphic on 'One direction for sterling', click: tmsnrt.rs/2yjulkD
The sterling selloff, which sparked fears of a potential flash crash, has sent investors rushing for protection against more swings in the currency around the time of Britain’s expected departure.
Three-month implied volatility GBP3MO= rose above 10 vols for the first time since early April.
Andreas Koenig, head of global forex at Amundi, is among those with short sterling position. Concern is rising about a potential liquidity squeeze should more investors rush to dump sterling, he said adding that investors had now “taken the October 31 deadline a bit more seriously.”
Hedge funds are increasingly “shorting” sterling - essentially betting it will fall - with data showing that hedge funds increased net short sterling positions to $6.11 billion in the week to July 23, the highest in nearly a year.
For a graphic on 'GBP implied vols rise above 10 vols', click: tmsnrt.rs/2ymfIgA
But no-deal Brexit may not be fully priced yet - the price of options expiring after Oct. 31 is elevated, but well below levels seen before the initial March 29 deadline.
Neil Jones, head of European hedge fund sales at Mizuho, said FX markets had factored in about a 20% chance of no-deal Brexit but were starting to price in a 50% chance.
“Sterling/dollar will continue a lower trend in reaction to weekend UK political developments,” he said.
The currency is also being pressured by the likelihood of an interest rate cut in coming months. The Bank of England is expected to keep interest rates on hold this week but money markets are fully pricing in a rate cut by end-January 2020.
For a graphic on 'BOE rate cut bets on the rise', click: tmsnrt.rs/2MonxL2
Reporting by Olga Cotaga; Additional reporting by Tommy Wilkes and Sujata Rao; Editing by Andrew Heavens