By Olga Cotaga
LONDON (Reuters) - Sterling sunk more than 1% to a 28-month low on Monday, as more investors scrambled to factor in the growing risk of a no-deal Brexit and the chance that new British Prime Minister Boris Johnson will call an early 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. Options markets imply that a fall below $1.23 opens the door to a bigger plunge.
By 1310 GMT, as Johnson repeated to British media that while he wanted to secure a new trade deal the UK was going to leave the EU on Oct. 31 with or without an agreement, sterling had fallen 1.1% versus the dollar to $1.2242 and 1.1% to 90.855 pence per euro.
Against the dollar sterling has now lost 7% of its value since May.
"Political risk is finally getting priced. 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 Millenium 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.
Until recently, most investors had believed a last-minute agreement would be reached but the war of words between Britain and the EU is escalating, with Ireland scolding Johnson's approach as "unhelpful".
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.
This followed comments by senior ministers on Sunday that the government was working on the assumption that the EU would not renegotiate its withdrawal deal, so it was ramping up preparations to leave on Oct. 31 without transition agreements in place.
The 27 other EU members have repeatedly said publicly and privately that the divorce settlement is not up for barter.
Many investors say a no-deal Brexit could tip Britain's economy into a recession.
Adding to the pound's travails is the possibility Johnson would call an early parliamentary election. His Conservative Party has risen in opinion polls since he 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.
"With the new government rhetoric on the hard Brexit firming and the rising likelihood of early elections, sterling should remain under pressure and ahead towards 0.95 pence and below $1.20 levels over the coming months," ING analysts told clients.
RUSH FOR OPTIONS
The sterling selloff has sent investors rushing for protection against more swings in the currency around the time of Britain's expected departure. Three-month implied volatility rose above 10 vols for the first time since early April.
There is also growing interest in "shorting" sterling - essentially a bet 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.
Analysts say the currency does not yet fully price in a no-deal Brexit.
Price action suggests the FX options market is not convinced the threat of a no-deal Brexit is as great as the British government makes out. The price of options expiring after the Oct. 31 deadline is elevated, but still below those seen before the initial March 29 deadline.
Some banks have even forecast the pound at parity against the euro and the dollar should a no-deal Brexit come to pass.
BMO Capital Markets reckons the pound will hit $1.16 over the next three months.
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.
On Thursday, the Bank of England is expected to keep interest rates on hold but may strike a more dovish tone given the rising risk of a no-deal Brexit.
Money markets are now fully pricing in a rate cut before end of January 2020, which is further weighing on the pound.
(Reporting by Olga Cotaga; Additional reporting by Tommy Wilkes and Sujata Rao; Editing by Frances Kerry and Alison Williams)