By Olga Cotaga
LONDON (Reuters) – Sterling plunged to a 27-month low against the dollar on Tuesday and hit new six-month lows versus the euro, extending losses as the two candidates to be Britain’s next prime minister vied to outgun each other on taking a harder Brexit stance.
Their positions appear to be leading markets to price a sharply higher risk of Britain leaving the European Union on October 31 without any transition trading agreements in place. That would potentially force the Bank of England to cut interest rates to stave off economic catastrophe.
Sterling which already fell half a percent on Monday is now headed for its biggest one-day fall since March, after Boris Johnson and his rival to be Conservative Party leader, Jeremy Hunt, said late on Monday they would not accept the so-called Northern Irish backstop element of Theresa May’s Brexit deal.
Both are trying to appeal to the majority of the Tory party members who are keen to make a clean break with the EU.
The contest between Johnson and Hunt “has transformed into an arms race of who is a bigger Brexiter,” said Vasileios Gkionakis, global head of forex strategy at Lombard Odier.
The backstop, one of Brussels’ principal demands in Brexit negotiations, is designed to prevent the return of a hard border between EU-member Ireland and British province Northern Ireland. If implemented, the U.K. would follow many EU rules until arrangements are made to avert a hard border.
“The market is pricing in a higher probability of a no-deal Brexit and an increase of economic pressure … You have the perfect storm for sterling,” Gkionakis added.
The British currency weakened 0.8% on Tuesday to $1.2409 <GBP=D3>, the lowest since April 2017, mirroring the “flash crash” on Jan. 3.
Against the euro the pound fell 0.5% to a low of 90.42 pence <EURGBP=D3>, the lowest since Jan. 11.
The weakness extended even after employment data showed average weekly earnings unexpectedly rose 3.4% year-on-year in the three-months to May. However, the labour market strength is widely attributed to employers hiring workers who they can later lay off if needed.
And employment growth slowed to post the weakest increase since the three months to August last year, in a sign that labour market may soon start feeling the heat.
Money markets are now pricing a roughly 50% chance of a BOE rate cut by end-year, having increased their bets after recent comments by governor Mark Carney were viewed as dovish <BOEWATCH=>.
Nomura strategist Jordan Rochester attributed the pound’s lurch lower to investors’ renewed interest in hedging sterling risks.
“The FX market already has a sizeable short sterling positioning on. But I am worried that volatility is starting from a very low base and hedging flows will be picking up further,” Rochester told clients.
According to data from the Commodity Futures Trading Commission, the week to July 9 saw speculators increased net short sterling positions to $5.69 billion – the fourth consecutive week of increase.
Implied volatility in sterling measured by the cost of six-month options contracts, which encompasses the Oct. 31 Brexit deadline, rose to a five-week high. Three-month vol is at the highest since April <GBP6MO=FN> <GBP3MO=FN>.
But despite the clock ticking down to October, most investors believe a deal will eventually be reached.
Only 20% of respondents surveyed by Bank of America Merrill Lynch expect the U.K. to leave the EU on or before the current October deadline and about 60% put the probability of a no-deal Brexit below 40%.
(Reporting by Olga Cotaga; Editing by Andrew Heavens)