Sterling firmed today after two days of losses to touch three-week highs versus the euro but options markets signalled pain ahead, betting on a greater risk of a no-deal Brexit under Britain's new leader Boris Johnson as economic stress worsens.
Investors are awaiting a speech by Johnson later in the day after his formal appointment as prime minister.
He won the election to lead the Conservative Party and the country on a campaign to take the UK out of the European Union by October 31, whether or not a transitional trade agreement is in place.
Many fear Johnson could pitch the country into a showdown with the EU and trigger a constitutional crisis at home, as many lawmakers have pledged to bring down any government that tries to force a no-deal Brexit.
UK economic data has also been dismal in recent months, with a recession seen likely.
Sterling stands less than half a percent off the 27-month low it hit recently against the dollar.
It was up 0.4% at $1.2481. Against the euro, it also rose 0.4% as the single currency weakened to three-week low.
Investors are also increasing their bias for sterling puts over calls in the three and six-month sterling-dollar risk-reversals market, with the three-month bias the greatest since April.
ING analysts said Boris Johnson faced a battle with a divided parliament over the no-deal scenario.
"A general election is increasingly likely - maybe even inevitable. This suggests a softer pound, meaning that any sterling strength should be faded in our view," they told clients, predicting the currency would approach 0.95 pence per euro and fall below $1.20 to the dollar.
However, the risk of a no-deal Brexit is still considered to be below 50%, and options do not seem to be fully pricing a no-deal scenario, with implied volatility well below the levels of before the original March 31 Brexit deadline.
Many reckon sterling moves will be contained until there is greater clarity on Brexit, given the currency has fallen over 6% since May against the dollar and parliament starts its summer recess tomorrow.
Fahad Kamal, chief market strategist at Kleinwort Hambros, expects Johnson to adopt a pragmatic stance on Brexit once in office, allowing sterling "a slow grind upwards."
"Regardless of politics, sterling has been reliably mean-reverting over the past 50 years and it's very cheap no matter now you look at it, whether in terms of purchasing power or in real terms," he added.
