Sterling in defensive mood on concerns about no-deal Brexit

Sterling was on the back foot on Tuesday as investors worried Boris Johnson, the front-runner to become the UK’s next prime minister, would trigger a “hard Brexit” from the European Union, widely seen as a major risk for the British economy.

The euro briefly touched the lowest in five weeks due to growing expectations European Central Bank President Mario Draghi will signal a rate cut in September at a policy meeting later this week to keep inflation expectations on track.

The New Zealand dollar fell after Bloomberg News reported that the country’s central bank is refreshing its strategies for unconventional monetary policy, but trading in other Asian currencies was subdued as investors awaited major developments in China-U.S. trade negotiations.

The dollar edged higher against the yen but was hemmed in against other major currencies on expectations for a U.S. Federal Reserve rate cut next week.

Speculation over the likelihood of a no-deal Brexit and questions over how far major central banks will ease monetary policy are likely to set the tone for currency markets in coming weeks, traders and analysts said.

“Johnson is expected to become the new prime minister, so there is a real chance of a hard Brexit,” said Takuya Kanda, general manager of research at Gaitame.Com Research Institute in Tokyo.

“In the short term, further declines in the pound could be limited because positions are already very short. In the medium term, sentiment for sterling will remain soft.”

The pound traded at $1.2459, within striking distance of a 27-month low of $1.2382 reached last week.

Sterling has fallen 3.7% versus the dollar in the past three months due to uncertainty about how Britain will avoid a no-deal exit from the EU.

Britain’s Conservative Party will announce the results of a leadership election on Tuesday, with Johnson widely expected to win, setting him up to become prime minister on Wednesday.

There is growing speculation Johnson will pull Britain out of the EU on Oct. 31 without a trade deal in place.

Hedge funds have increased short positions on the pound to a 10-month high in the week to July 16, Commodity Futures Trading Commission data shows.

The New Zealand dollar fell 0.4% to $0.6734, putting the kiwi on track for a third straight day of losses.

The Reserve Bank of New Zealand has “begun scoping a project to refresh our unconventional monetary policy strategy and implementation,” the central bank said according to a Bloomberg News article published on Tuesday.

The RBNZ kept the official cash rate at a record low of 1.50% in June but warned that interest rate cuts may be necessary in the future.

Interest rate swaps showed a 79% chance of a 25 basis point rate cut at the RBNZ’s next policy meeting on Aug. 7.

“The Bloomberg story has struck a nerve because it can be linked to speculation about a rate cut at the next policy meeting,” said Yukio Ishizuki, foreign exchange strategist at Daiwa Securities in Tokyo.

“It’s possible for the kiwi to go a little lower. The currency market is focused completely on central bank policy moves.”

The euro briefly fell to $1.1191, the lowest since June 19, as traders awaited the ECB’s policy meeting and Draghi’s comments at a news conference on Thursday.

Traders see a 43% probability that European policymakers will lower a key deposit rate by 10 basis points to minus 0.50% to combat risk from global trade tensions.

Economists surveyed by Reuters expect the ECB to change its forward guidance to pave the way for a rate cut in September.

The dollar traded at 108.14 yen. The dollar index was marginally higher at 97.435.

The U.S. central bank is widely expected to lower its target range of 2.25%-2.50% by 25 basis points at a meeting ending July 31, but expectations for a larger 50-basis point cut have waxed and waned due to mixed signals from Fed policymakers.