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Sterling short sellers hold their nerve as no-deal Brexit risk remains

A bill outlawing a no-deal Brexit is not enough to stop currency traders from betting that the U.K. will crash out of the EU without an agreement next month.

While some twitchy investors are beginning to unwind their bets that the pound will fall, short positions on sterling are still close to the most in two years, according to data from the CFTC.

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Parliament reopened after a court ruled against Prime Minister Boris Johnson's proroguing.
Source: Associated Press

They are playing a dangerous game. The pound has risen 2.4% from a 34-year low reached Aug. 9 as Parliament passed a law forcing Prime Minister Boris Johnson to request an extension to Article 50 if he fails to reach a deal to leave the European Union by the end of an EU summit Oct. 17.

Should a deal be agreed or an extension requested, the pound is likely to rise substantially, subjecting short sellers to a "squeeze," forcing them to buy sterling to cover their positions, in turn pushing the pound up further.

If a formal request for an extension is granted, the pound could return to $1.30 to $1.33 in the short term, according to John Goldie, a foreign-exchange dealer at Argentex. That would represent an 8% jump from the $1.23 level it was trading at about 8 a.m. ET.

Traders are still betting on a weaker pound because of a lack of clarity about what will happen when the U.K. is currently scheduled to leave the EU. While Johnson has stepped up his efforts to secure an agreement with the EU since the no-deal law was passed, he has also continued to insist that the U.K. will leave Oct. 31 with or without a deal.

After having suspended Parliament, until it was ruled unlawful by the Supreme Court on Sept. 24, it is clear that Johnson has no qualms about pushing the limits of the constitution to get the U.K. out of the bloc by the end of October.

Still, the passing of the law aimed at stopping a no-deal Brexit has led some to reconsider their wagers. Hedge fund manager and vocal Brexit supporter Crispin Odey, one of the most prominent investors to short the pound, revealed at the end of August that he had closed his positions, and others appear to be following suit.

Net short positions on the pound fell to 26.9% of open interest Sept. 16, according to the latest data from the CFTC. They were at 32.3% on Aug. 12, the most since the aftermath of the referendum when it reached 39.7% in April 2017.

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"Let's assume that speculative positioning turns around, then I would reckon that a greater than 10% move is on the cards," said Andreas Steno Larsen, a senior global strategist at Nordea Research. A firm commitment from the EU to renegotiate the Irish backstop element of the withdrawal agreement would be a tipping point, he said.

Capital flows and risk premiums suggest the pound is undervalued by around 5% to 12% in the short term, according to Sven Schubert, a currency strategist at Vontobel. He expects a revaluation of around 5% to 10% against the U.S. dollar in the event of a deal but does not see the pound recouping its almost 20% loss since the referendum in June 2016.

"Long term valuation models, like purchasing power parity, are pointing to an appreciation potential of approximately 20% against the U.S. dollar, but we doubt that the pound would close the valuation gap completely," Schubert said, pointing to the U.K.'s already depreciating currency before the referendum and the subsequent divergence in economic growth with the U.S.

For all the risks of holding short positions on the pound in these uncertain times, the rewards are also potentially great. For some, the recent advance in sterling is just an opportunity to take fresh short positions from a better level.

"If the extension bill can be sidestepped by Boris and his team, and the market fears that this risk is still very real, then another trip towards $1.20 may be on the cards in the coming weeks," said Goldie.