* Graphic: World FX rates in 2019 http://tmsnrt.rs/2egbfVh
* Graphic: Trade-weighted sterling since Brexit vote http://tmsnrt.rs/2hwV9Hv (Adds quotes, context, chart)
By Olga Cotaga
LONDON, July 22 (Reuters) – Sterling fell nearly half a percent on Monday with the outlook turning bleak as traders increased their bets on a no-deal Brexit before the result of the Conservative party’s leadership election.
The pound’s weakness was in sharp contrast to the general calm in the developed market currency space and signalled growing unease among investors over the likelihood of Eurosceptic former foreign minister Boris Johnson becoming the next prime minister.
“The market will look to price in the chance of a no-deal Brexit at 50/50,” said Neil Jones, head of European hedge-fund sales at Mizuho. Morgan Stanley said it now sees a 30% chance of Britain leaving the EU without a deal compared to 25% earlier.
The last votes to choose a new Conservative party leader are expected to be handed in late Monday, followed by an announcement mid-morning on Tuesday. Party activists choose the leader, expected to replace Theresa May as prime minister.
The pound was last down 0.3% at $1.2467, not far from the 27-month low reached last week, having declined 1.8% against the dollar so far this month. Against the euro, it also fell to 89.98 pence.
Currency and bond markets have been rattled by fears that a British government under Johnson would increase the risk of a no-deal Brexit, as he repeatedly said that Britain must leave the European Union by Oct. 31 with or without a deal.
Market participants have been buying more options to protect against losses in sterling since early May and have consolidated their positions in the past few days, according to three-month sterling risk-reversals, which measure demand for buy and sell options on the British currency.
Three-month implied volatility in the pound has risen since the beginning of the month and has hit its highest level since early April, signalling traders are bracing for a rocky ride for the pound in the currency markets.
Still, levels are well below the highs achieved before Britain’s initial March 29 deadline to leave the EU, which was extended after May failed to pass a withdrawal deal in parliament.
Hedge funds have also increased their short positions on the pound to $5.94 billion via currency futures in the week to July 16, a 10-month high, based on data provided by the Commodity Futures Trading Commission.
“Sterling shorts have grown further and are moving in line with both EUR/GBP and GBP/USD,” said Kit Juckes, macro strategist at Societe Generale.
“A glance at bookmakers’ apps this morning suggests Boris Johnson is 66/1 on to win the Conservative crown,” Juckes said. His rival, Jeremy Hunt, faces odds of 25 to 1, he added.
But not everyone in the market sent depressing thoughts on sterling.
Some analysts expect the pound to hover around current levels given that the U.K. parliament will enter summer recess shortly and therefore won’t make any new progress on Brexit negotiations.
“Sterling already trades at crisis levels and typically struggles to go much lower. A no-deal Brexit is a risk and would certainly make new lows in the pound, but we do not expect the market to assign a higher hard Brexit premium than before until parliament returns after the summer break in September,” said Jordan Rochester, forex strategist at Nomura.
In a note to clients, Citi analysts said that a no-deal Brexit will likely prompt the Bank of England to cut interest rates, which “could help offset the negative economic effects of â€˜crash outâ€™ and support the currency.”
(Reporting by Olga Cotaga Editing by Peter Graff)