LONDON (Reuters) - The British pound wobbled briefly on Tuesday as Britain looked set for a snap December election, but its recent surge on hopes of a smooth Brexit look may be capped by outside risks that the various election outcomes could bring.
Sterling has gained more than 5 percent over the last three weeks against the U.S. dollar, and stocks rallied as fears of Britain crashing out of the European Union faded after European policymakers agreed on a third Brexit extension until Jan. 31.
Graphic: Trade-weighted sterling since Brexit vote - tmsnrt.rs/2hwV9Hv
But the growing optimism has been punctured this week as market watchers worried that some of those concerns that have dogged investor sentiment for most of this year may return to haunt the pound if the election result is not a clear one.
While pollsters and financial markets expect the ruling Conservative Party to win the December vote, market watchers say those probabilities can shift rapidly as the election date approaches - as shown in the 2017 general election when the opposition Labour Party nearly doubled its support.
“I’m short the pound as for now it’s going to be all about poll tracking and hedging for downside risks,” said Jordan Rochester, a currency strategist at Nomura based in London who has purchased a seven-week put option on the pound and has gone long on euro/sterling.
A seven-week option overlaps the possible British election date around Dec. 11 and gives the buyer of the option the right to profit from any potential drop in the value of the currency after the vote.
Prediction site Betfair puts the probability of a Conservative Party victory at more than 80% and the probability for a Labour Party victory at around 10%. They were both neck-to-neck as recently as June.
British lawmakers approved on Tuesday the government’s timetable for passing a law which calls for an early general election on Dec. 12.
But the date is not set in stone yet. Johnson will call off the election plan if parliament votes to lower the voting age or allows EU citizens to vote as such changes would mean a six-month delay, his political spokesman said.
An election has also taken some of the steam out of the pound’s rally as investors braced for a multitude of scenarios.
On Tuesday, the pound was trading around $1.2888, about 1% below a five-month high of above $1.30 hit last week. Against the euro, the British currency was flat at 86.23 pence, hovering below a five-month high versus the euro.
Graphic: World forex rates in 2019 - tmsnrt.rs/2egbfVh
“I don’t see immediately that the risk-reward ratio has shifted in favour of the pound and most of the longer term players are also adopting a similar wait-and-see approach,” said Ugo Lancioni, head of global currency at Neuberger Berman.
Below the relative calm in the cash markets, traders are bracing for more volatility around the election results with two-month and three-month volatility gauges for the pound holding firm compared to a drop in one-month volatility.
Spreads between two-month and one-month implied volatility gauges for the pound, an indicator of perceived swings in the British currency - have widened to their highest levels in six weeks, indicating traders were expecting more volatility after the election than over the next one-month period.
Graphic: GBP volatility curve - here
An election also potentially throws up a no-deal Brexit scenario, a risk which is now almost priced out of the market.
In its latest updated forecasts, Morgan Stanley and Goldman Sachs put the risk of a no-deal Brexit at a low 5% and assign a 75% probability of a deal followed by the likelihood of 20% for Britain opting to stay within the European Union.
However, Ross Hutchison, a rates fund manager at Aberdeen Standard Investments, said two potential scenarios where a no-deal Brexit can be back on the table is if a Conservative Party victory emboldens some of the hardline factions in the party to withdraw support for the current withdrawal bill before the next extension deadline at end-January 2020.
A second scenario would be if a possible victory for the opposition parties including the Labour and the Liberal Democrat parties encourages them to hold a second EU membership referendum in which a majority again vote to leave the bloc.
“Neither of these cases are ‘base case’ – but ‘no deal’ cannot be totally ruled out,” he said.
Graphic: GBP volatility - here
Reporting by Saikat Chatterjee, Olga Cotaga, Dhara Ranasinghe and Elisabeth Howcroft; Editing by Kirsten Donovan and Mark Heinrich