Wires

UPDATE 1-Sterling holds the line as FX markets try to price UK election risks

Saikat Chatterjee and Olga Cotaga

* Graphic: World FX rates in 2019 http://tmsnrt.rs/2egbfVh

* Graphic: Trade-weighted sterling since Brexit vote http://tmsnrt.rs/2hwV9Hv (Recasts, adds graphics, quotes)

LONDON, Oct 29 (Reuters) - The British pound wobbled briefly on Tuesday as Britain looked set for a snap December election but its recent surge on hopes of a smooth Brexit look capped by the outside risks that the various election outcomes could bring to that scenario.

Sterling has gained more than 5 percent over the last three weeks against the greenback and stocks rallied as fears of Britain crashing out of the European Union faded after European policymakers agreed on a third extension until end-January.

But that growing optimism has been punctured this week as market watchers worried that some of those concerns that has dogged investor sentiment for most of this year may return to haunt the pound if the election result is not a clear one.

While pollsters and financial markets expect the ruling Conservative Party to win the December vote, market watchers say those probabilities can shift rapidly as the election date approaches as evident during the 2017 general elections when the opposition Labour Party nearly doubled its support.

"Im short the pound as for now its going to be all about poll tracking and hedging for downside risks," said Jordan Rochester, a currency strategist at Nomura based in London who has purchased a seven-week put option on the pound and has gone long on euro/sterling.

A seven-week option overlaps the possible British election date around December. 11 and gives the buyer of the option the right to profit from any potential drop in the value of the currency after the election.

Prediction site Betfair puts the probability of a Conservative Party win at more than 80% while the probability for a Labour Party victory at around 10%. They were both neck-to-neck as recently as June.

After parliament refused Johnson his third demand for an election on Monday, the country looks set towards a December election after Johnson's bet on breaking the Brexit deadlock with an early vote gained support from opposition parties

LESS ATTRACTIVE

An election has also taken some of the wind out of the pound's rally as investors braced for a multitude of scenarios.

On Tuesday, the pound was trading around $1.2857, about 1% below a five-month high of above $1.30 hit last week. Against the euro, the British currency was holding below a five-month high versus the euro.

"I don't see immediately that the risk-reward ratio has shifted in favour of the pound and most of the longer term players are also adopting a similar wait-and-see approach," said Ugo Lancioni, head of global currency at Neuberger Berman.

Below the relative calm in the cash markets, traders are bracing for more volatility around the election results with two-month and three-month volatility gauges for the pound holding firm compared to a drop in one-month volatility.

Spreads between two-month and one-month implied volatility gauges for the pound, an indicator of perceived swings in the British currency has widened to its highest levels in six weeks indicating traders were expecting more volatility after the election than over the next one-month period.

NOT RULING OUT

An election also potentially throws up a no-deal Brexit scenario, a risk which is now almost priced out of the market.

In its latest updated forecasts, Morgan Stanley and Goldman Sachs puts the risk of a no-deal Brexit at a low 5% and assigns a 75% probability of a deal followed by the likelihood of 20% for Britain opting to stay within the European Union.

However, Ross Hutchison, a rates fund manager at Aberdeen Standard Investments said two potential scenarios where a no-deal Brexit can be back on the table is if a Conservative Party win emboldens some of the hardline factions in the party to withdraw support for the current withdrawal bill before the next extension deadline at end-January 2020.

A second scenario would be if a possible victory for the opposition parties including the Labour and the Liberal Democrat parties encourages them to hold a second referendum where a majority might yet again vote to leave the European Union.

"Neither of these cases are base case but no deal cannot be totally ruled out," he said.

(Reporting by Saikat Chatterjee, Olga Cotaga, Dhara Ranasinghe and Elisabeth Howcroft; Editing by Kirsten Donovan and Angus MacSwan)