Pound Traders Seen Downplaying Risk of a Johnson No-Deal Brexit

(Bloomberg) -- Pound traders may be underplaying the risk of a no-deal Brexit under Boris Johnson after the frontrunner for the U.K.’s next prime minister said he is “not bluffing.”

The options market has become more pessimistic in recent weeks on sterling’s fortunes over the next six months compared to the three-month period up to the Oct. 31 deadline to leave the European Union. The risk premium is likely to grow if Johnson is confirmed as prime minister this month, according to MUFG and Mizuho Bank Ltd.

The pound’s fortunes have been dictated since the 2016 Brexit referendum by the growing and ebbing prospects for a deal with Brussels and approval by Parliament. The currency is near its lowest level this year after Prime Minister Theresa May stepped down and both contenders to replace her have said they are ready to walk away from the bloc.

“The market is heavily underestimating the chances of a no deal,” said Neil Jones, head of hedge fund currency sales at Mizuho. “Whilst volatility is still low, it’s worth putting on some downside protection through the October-December period.”

Pound risk-reversals, a gauge of options sentiment and positioning, are at 175 basis points in favor of selling sterling over six months, compared to 81 basis points over three months. The spread between the two is already near the widest since 2016. While bets on swings in the currency are also higher over six months, those have slid so far in July.

For Royal Bank of Canada’s chief currency strategist Adam Cole, the risk of a hard Brexit is now around 30%-35%, although it is hard to separate from the risk of a general election. The market is moving to price in both outcomes thanks to “ever greater certainty that Boris Johnson will win the leadership contest,” he said.

As Conservative party members start to voting in the leadership ballot, a YouGov poll published in the Times indicated Johnson is backed by 74% of them, compared to 26% for rival Jeremy Hunt.

“The options market has been pricing in more downside risks for the pound after the end of the Article 50 period in October,” said Lee Hardman, a currency strategist at MUFG. “We don’t believe the market has fully adjusted yet.”

To contact the reporter on this story: Charlotte Ryan in London at cryan147@bloomberg.net

To contact the editors responsible for this story: Ven Ram at vram1@bloomberg.net, Neil Chatterjee, Scott Hamilton

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