* Graphic: World FX rates in 2019 http://tmsnrt.rs/2egbfVh
* Graphic: Trade-weighted sterling since Brexit vote http://tmsnrt.rs/2hwV9Hv (Adds quotes, context, updates prices)
By Olga Cotaga
LONDON, July 16 (Reuters) – Sterling plunged to a six-month low against the euro on Tuesday and approached two-year lows against the dollar, as the two candidates to be Britain’s next prime minister vied to outgun each other on taking a harder Brexit stance.
Markets see their positions as sharply raising the risk of Britain leaving the European Union on October 31 without any transition trading agreements in place, potentially forcing the Bank of England to cut interest rates to stave off economic catastrophe.
Boris Johnson, front-runner to be chosen leader by the Conservative Party, as well as his rival Jeremy Hunt said late on Monday they would not accept the so-called Northern Irish backstop element of Theresa May’s Brexit deal.
Both are trying to appeal to the majority of the Tory party members who are keen to make a clean break with the EU.
The contest between Johnson and Hunt “has transformed into an arms race of who is a bigger Brexiter,” said Vasileios Gkionakis, global head of forex strategy at Lombard Odier.
The backstop, one of Brussels’ principal demands in Brexit negotiations, is designed to prevent the return of a hard border between EU-member Ireland and British province Northern Ireland. If implemented, the U.K. would follow many EU rules until arrangements are made to avert a hard border.
The Brexit concerns, coupled with signs of a rapidly deteriorating economy, have taken sterling near its lowest levels in years.
“The market is pricing in a higher probability of a no-deal Brexit and an increase of economic pressure,” said Gkionakis.
“You have the perfect storm for sterling.”
The British currency weakened 0.5% on Tuesday to $1.2455 , a six-day low. If it falls below $1.2439 it would sink to its lowest in more than two years, excluding the “flash crash” on Jan. 3 when it dropped to $1.2409.
Against the euro the pound fell 0.3% to a low of 90.25 pence , the lowest since Jan. 11.
It failed to budge higher even after employment data showed average weekly earnings unexpectedly rose 3.4% year-on-year in the three-months to May. However, the labour market strength is widely attributed to employers hiring workers who they can later lay off if needed.
Speculators increased their net short sterling positions for a fourth consecutive week in the week to July 9 to $5.69 billion, according to Commodity Futures Trading Commission data.
Implied volatility in sterling measured by the cost of six-month options contracts, which encompasses the Oct. 31 Brexit deadline, rose to a two-week high on Tuesday. One-month volatility is at the highest since April
But despite the clock ticking down to October, most investors believe that a deal will eventually be reached.
Only 20% of respondents surveyed by Bank of America Merrill Lynch expect the U.K. to leave the EU on or before the current October deadline and about 60% put the probability of a no-deal Brexit below 40%.
(Reporting by Olga Cotaga;)