Brighter future for sterling seen if no-deal Brexit is averted

* Sterling downside risk receding

* Pound very cheap on historical basis

* But major Brexit risks remain

By Tom Finn

LONDON, Jan 15 (Reuters) - Britain's plans to leave the European Union could be thrown into disarray by a vote in parliament later on Tuesday but bets are mounting that a chaotic no-deal Brexit can be avoided and that sterling will rise from here.

After slumping 7 percent in 2018, the pound has started the year on the front foot. It scaled $1.29 on Tuesday, hours before British lawmakers are due to vote on the withdrawal agreement Prime Minister Theresa May negotiated with the EU.

They are expected to reject the deal, barely 2-1/2 months before Britain is due to leave the bloc, opening up a range of outcomes, from quitting with no agreement on future relations to halting Brexit altogether.

But even amidst the tumult some investors are starting to view medium-term sterling valuations as decently priced, market positioning overly negative and the dollar topped out.

They reckon the chances of a no-deal Brexit -- long seen as the worst case scenario for the pound -- are diminishing as parliament exerts greater control over the process.

On Friday, hedge fund manager Crispin Odey, a major donor to the Brexit campaign, went as far as to say he now expects the project to be abandoned altogether and that he is positioning for the pound to strengthen.

"A pretty poor outcome from Brexit has already been discounted so sterling, from here, will move more on good news than bad," said Kit Juckes, global head of FX strategy at Societe Generale.

"Anything short of a no-deal Brexit is likely sterling positive."

This view is evident in the options market where the risk of sterling falling against the dollar is deemed the lowest in over seven months, according to one-month risk reversals .

The outlook for a sterling bounce is also supported by valuations. Based on the real effective exchange rate -- a currency's value against trade partners' currencies, adjusted for inflation -- sterling is 6 percent below its five-year average, and 14 percent below its 20-year average.

"At the moment a no-deal is looking very unlikely so UK assets are probably undervalued and there is some upside potential in the currency," said Roberto Coronado, a portfolio manager at PineBridge Investments. He has a small long position in sterling versus the dollar.

Odey said he had changed his view in the last month and that the pound "looks like it could be quite strong" and rise to $1.32 or $1.35 against the dollar, from around $1.27 currently.

Odey Asset Management's flagship fund had previously reaped the benefits of betting against UK assets amid wider market fears about the impact of Brexit.

NO NO-DEAL

Foreign exchange strategists polled by Reuters last week saw the pound gaining more than 8 percent against the U.S. dollar this year -- assuming Britain and the EU part ways amicably.

Ruling out a no-deal Brexit, as some lawmakers are seeking to do, would allow traders to actually take a directional view and buy sterling.

Lessening the risk of serious upheaval when Britain leaves the world's biggest trading bloc on March 29 could also allow the Bank of England to raise interest rates, which would further underpin the pound.

A Reuters poll of economists published on Tuesday showed respondents expect some kind of deal to pass, followed by a 25 basis-point rate rise later in the year.

They overwhelmingly saw a free-trade agreement between Britain and the EU as the most likely eventual outcome of Brexit.

With the U.S. Federal Reserve looking set to pause its own policy tightening, that would suggest potential for sterling strength.

"If we get through Brexit by avoiding no-deal, the BoE will be limbering up for rate hikes," said Sarah Hewin, chief Europe economist at Standard Chartered. "In 12 months we have sterling recovering to the low $1.40s."

But getting there could be "painful", Hewin added.

Others said positioning for a brighter sterling outlook remains tricky. LMAX Exchange analyst Joel Kruger said he found it too risky to wade in and planned to take option positions on sterling only if it breaks above $1.33 or falls below $1.23.

The pound was trading at $1.2850 on Tuesday.

One way to do it is via implied volatility options -- a bet on sterling staying erratic, although with sterling volatility still higher than many emerging market currencies and the highest of all G10 currencies, that is an expensive trade.

Betting the pound will remain in a relatively tight range against the euro -- another currency that could be expected to move on Brexit news -- is another option, according to Juckes.

Sterling traded mostly in a range of 86 to 90 pence against the euro last year. It swung more violently versus the dollar but that is partly down to the greenback's own volatility in 2018.

(Additional reporting by Sujata Rao and Ritvik Carvalho; Editing by Catherine Evans)

2019-01-15 17:11:46

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