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LONDON, July 29 (Reuters) - Sterling extended losses and fell below $1.23 towards 30-month lows on Monday, as more investors rushed to factor in the growing risk of a no-deal Brexit and the chance that new British Prime Minister Boris Johnson will call an early election.
A still-deeper fall in sterling remains on the cards; all metrics show that a disorderly British exit from the European Union is far from being fully priced in. Options markets imply that a fall below $1.23 opens the door to a bigger plunge.
"The market is now increasingly concerned about hard Brexit being a possibility," said Esther Maria Reichelt, an analyst at Commerzbank in Frankfurt.
Until recently, most investors had believed a last-minute agreement would be reached. This view is being strongly tested - the government said on Monday it assumed there would be a no-deal Brexit because a "stubborn" European Union was refusing to renegotiate their divorce.
This followed comments by senior ministers on Sunday that the government was working on the assumption that the EU would not renegotiate its withdrawal deal, so it was ramping up preparations to leave on Oct. 31 without transition agreements in place.
The pound dropped 0.7% to $1.2286, the lowest it has been since mid-March 2017. It was also 0.6% lower against the euro, touching 90.43 pence, below the key psychological level of 90.
Johnson took over last week as premier with a pledge to leave the EU by Oct. 31 with or without a deal. Many investors say a no-deal Brexit could tip Britain's economy into a recession.
Adding to the pound's travails is the possibility Johnson will call an early parliamentary election to cement his position. His Conservative Party has risen in opinion polls since he became leader, according to YouGov, which showed support for the party at 31%, well above the opposition Labour.
An election win could allow Johnson to overcome parliament's opposition to a no-deal Brexit.
Meanwhile, the war of words between Britain and the EU is escalating, with Ireland scolding Johnson's approach as "unhelpful".
"With the new government rhetoric on the hard Brexit firming and the rising likelihood of early elections, sterling should remain under pressure and ahead towards 0.95 pence and below $1.20 levels over the coming months," ING analysts told clients.
RUSH FOR OPTIONS
The sterling selloff has sent investors scrambling for protection against more swings in the currency around the time of Britain's expected departure date. Three-month implied volatility rose above 10 vols for the first time since early April.
There is also growing interest in "shorting" sterling - essentially a bet it will fall - with data showing that hedge funds increased net short sterling positions to $6.11 billion in the week to July 23, the highest in nearly a year.
Analysts say the currency does not yet fully price in a no-deal Brexit.
Price action suggests the foreign exchange options market is not convinced the threat of a no-deal Brexit is as great as the UK government makes out. The price of options expiring after the Oct. 31 deadline is elevated, but still below those seen before the initial March 29 deadline.
"Nobody dares to bet on aggressive views," Reichelt said, adding that once they decided to do so, sterling could lurch lower "in big steps".
More than $800 million were locked in options contracts with a strike price of $1.23 in sterling/dollar, but not many options contracts have been bought beyond that level until around 1.20. So a fall below $1.23 could open the doors to a bigger plunge.
Some banks have even forecast the pound at parity against the euro and the dollar should a no-deal Brexit come to pass.
Neil Jones, head of European hedge-fund sales at Mizuho, said FX markets had factored in about a 20% chance of no-deal (Brexit), which was "far from a base case most likely scenario".
"Sterling/dollar will continue a lower trend in reaction to weekend UK political developments," Jones added.
(Reporting by Olga Cotaga Editing by Sujata Rao and Frances Kerry)