LONDON (Reuters) - Sterling extended its decline on Monday as the outlook for the currency turned bleaker, with traders increasing their bets on a no-deal Brexit ahead of the results of the Conservative Party’s leadership election.
The pound’s weakness was in contrast to the general calm in broader currency markets, and signalled growing unease among investors over the likelihood of eurosceptic former foreign minister Boris Johnson becoming the next prime minister.
The result of the weeks-long internal party election will be announced on Tuesday, with Johnson widely expected to have beaten foreign minister Jeremy Hunt. The winner will become prime minister on Wednesday.
The pound last traded down 0.2% at $1.2476, not far from the 27-month low reached last week, having declined 1.7% against the dollar so far this month.
Against the euro, it fell to 89.98 pence.
Some investors are worried Johnson could pull Britain out of the European Union on Oct. 31 without a trade deal in place in order to appease members of his Conservative Party and frustrated pro-Brexit voters, three years after Britons voted by a narrow majority in a referendum to leave the EU.
“To save the Conservative Party, he (Johsnon) has to deliver Brexit on Oct. 31,” said Helen Thomas, CEO of macroeconomic consulting firm BlondeMoney.
Market participants have been buying more options since early May to protect against losses in sterling and have consolidated their positions in the past few days, according to three-month sterling risk-reversals, which measure demand for buy and sell options on the British currency.
Three-month implied volatility in the pound has risen since the beginning of the month and has hit its highest level since early April, signalling that traders are bracing for a rocky ride for sterling.
Still, levels are well below the highs achieved before Britain’s initial March 29 deadline to leave the EU, which was extended after Prime Minister Theresa May failed to pass a withdrawal deal in parliament.
(For a graphic on 'Implied sterling volatility surges around Oct 31 deadline', click here tmsnrt.rs/2O9MJHo)
Hedge funds have also increased their short positions on the pound to $5.94 billion via currency futures in the week to July 16, a 10-month high, based on Commodity Futures Trading Commission data.
“The market will look to price in the chance of a no-deal Brexit at 50/50,” said Neil Jones, head of European hedge fund sales at Mizuho.
Morgan Stanley said it now saw a 30% chance of Britain leaving the EU without a deal compared to 25% previously.
Though investors look anxious, BlondeMoney’s Thomas argued they aren’t worried enough.
“The risk (of a no-deal Brexit) is really, really underpriced now,” she said, adding that she expected to see sterling fall to parity against the euro in the event of Britain crashing out of the bloc without a deal.
Voting by Conservative Party members in the leadership election ends at 1600 GMT on Monday. The announcement of the winner is expected around mid-morning on Tuesday.
Some analysts expect the pound to hover around its current levels, at least for now, given that the UK parliament will enter summer recess shortly and therefore won’t make any new progress on Brexit negotiations.
“Sterling already trades at crisis levels and typically struggles to go much lower,” said Jordan Rochester, forex strategist at Nomura.
In a note to clients, Citi analysts said that a no-deal Brexit would likely prompt the Bank of England to cut interest rates, which “could help offset the negative economic effects of ‘crash out’ and support the currency.”
Reporting by Olga Cotaga; Editing by Gareth Jones