Any Brexit outcome under Boris Johnson, the favorite to succeed U.K. Prime Minister Theresa May, will only compound the recent poor run for the pound, currency analysts have projected.
Johnson emerged the comfortable victor in the second round of voting among Conservative party Members of Parliament (MPs) Tuesday, and looks highly likely to win the party leadership, in turn becoming Britain's next prime minister.
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A staunch Brexiteer, Johnson has vowed to take the U.K. out of the European Union on October 31 regardless of whether any deal is agreed with the bloc, a position which has drawn criticism from fellow leadership contenders.
But the U.K.'s unique political quandary at the moment means sterling has no easy way out in any of the possible scenarios to arise before the deadline.
Ray Attrill, head of FX strategy at National Australia Bank (NAB), told CNBC's "Capital Connection" Tuesday that "increasing conviction" that Johnson will become Conservative leader is "troubling" sterling, and questioned whether the former foreign secretary's leave at all costs approach was plausible.
"If the answer to that question is that he will not be allowed to do that, because parliament would obstruct him, does that mean that there is a risk of an early general election, which is something I think markets will fear almost as much as a no-deal Brexit?" Attrill said.
"I think there are still risks that the path of least resistance for sterling will continue to be down," he added. NAB has forecast the sterling-dollar exchange rate at 1.22 at the end of the third quarter.
Sterling's slide has been catalyzed by Johnson's emergence as the front runner for 10 Downing Street, trading at 1.2520 against the dollar on Tuesday afternoon, close to a five-and-a-half month low. It hit a six-month low of 1.1139 against the euro Tuesday, before European Central Bank (ECB) President Mario Draghi's dovish speech saw the euro tumble.
No deal 'a fair base case'
Markets have long held onto the possibility of a so-called "soft Brexit" or a revocation of Article 50, meaning Britain would remain in the EU. However, these scenarios have become increasingly unlikely given the growing likelihood that Johnson will take the helm.
After Johnson's resounding victory in the first round of voting, Lutfey Siddiqi, a professor at the London School of Economics, told CNBC that "no deal Brexit is a fair base case scenario now."
However, he highlighted an impasse resulting from the next prime minister being chosen solely by the Conservative membership.
"There's a fundamental contradiction in that any contender for Conservative leader that espouses a Brexit that will command the support of parliament cannot become leader," said Siddiqi.
"Conversely, the Brexit they will need to espouse to become Conservative leader cannot get support from parliament."
Siddiqi suggested that it would suit both the U.K. and the EU politically to allow the October 31 deadline to lapse, meaning the U.K. leaves without a deal, only then to return to the negotiating table and agree a similar deal to that presented by Theresa May, which failed to gain parliamentary support.
No easy way out
Stephen Gallo, European head of FX strategy at BMO, has assigned a 53% probability that Brexit happens on October 31, either through a no deal Brexit or a form of "managed no deal." In a recent note, he predicted that the pound will fall to 1.2100 against the dollar, while the euro would gain ground on sterling, climbing to 0.9008. He said "the noose is tightening" around the British currency as it careers toward a no-deal departure from the bloc.
In turn, BMO calls a 47% chance that the U.K. does not leave on October 31, resulting in a parliamentary no-confidence vote in the government, new elections and further ruptures within the Conservative and main opposition Labour parties. Such an eventuality, Gallo suggested in a recent note, would leave GBP/USD at 1.2300 and EUR/GBP at 0.8943.
Gallo suggested that the notion of MPs (Members of Parliament) blocking a no-deal departure reverting to WTO (World Trade Organization) terms was overestimated, given a lack of a clear legal route through which it could occur.
He also highlighted that in each of the three rounds of indicative voting which saw no-deal rejected by parliament, the number of MPs in favor of preventing a no-deal Brexit declined to a majority of one in the final vote.
"Based on our analysis of the facts and various political elements, we see no easy way out of Brexit for the broad value of the GBP that involves a solid and sustained rally over the next 3-6 months," Gallo added.
Five possible scenarios, but a general election looms
James Smith, developed markets economist at Dutch bank ING, set out five possible scenarios. The most likely, he hypothesized in a recent note, is a 35% probability that parliament passes a no confidence motion in the next leader, triggering a general election in late 2019 and thus delaying Article 50 for at least three months. Smith projected that prolonged uncertainty would send EUR/GBP to 0.95 and GBP/USD to 1.18.
Second most likely, at 25% probability, is for pro-Brexit MPs to reluctantly back a revamped deal with Brussels in order to avoid an election, meaning it passes through parliament. The anticipated market reaction, according to Smith, would see EUR/GBP hit 0.85 and GBP/USD rise to 1.34.
No-deal, either through the EU rejecting a further extension or a new leader pushing through a hard Brexit, is priced in as the third most likely of five scenarios at a 20% probability. This would see the collapse of sterling, with the euro's value drawing level with the pound and GBP/USD plummeting to just 1.10.
The next most likely outcome is a potential prime minister triggering a second referendum, in order to seek a further mandate without risking a general election. The ING note cites a report from the Eurasia Group which suggested that Johnson may be more open to this than he admits publicly, if only to "gain a mandate for a harder vision of Brexit."
In this instance, Smith theorized, Article 50 would be extended for at least six months, to which markets would react favorably, sending EUR/GBP to 0.82 and GBP/USD to 1.40.
The slimmest probability identified by ING, at 5%, is a revocation of Article 50. While parliament may prefer this over a no-deal exit, Smith suggested, "MPs could lack a legislative tool to force the new PM's hand."
Smith proposed that this would elicit the most favorable market reaction, with the euro dropping to 0.78 against the pound while sterling would rise to 1.47 against the dollar.
