Much like Italian rout, markets may not price Brexit risks until they hit

* Market calm may reflect shift in trader psychology

* Brexit headlines dominate news coverage but pound unmoved

* Investors say hard to price Brexit risks, easier to ignore

By Tommy Wilkes and Tom Finn

LONDON, June 14 (Reuters) - A catastrophic, messy Brexit might be looming for Britain next year but judging by how the pound is trading, one would hardly know it. Increasingly, it seems a risk is not a risk for financial markets until it actually hits.

The calm in sterling at such a juncture is leading some to draw parallels with Italy's mini-crisis where 2-1/2 months of relative calm following March 4 elections exploded onto markets at the end of May, prompting panicky last-minute selling.

The pound, which crashed to 31-year lows against the dollar immediately after Britain's June 2016 vote to leave the European Union, has since recovered about half of those losses. In recent weeks it has traded within tight ranges even as debates on how to exit -- within London's political establishment and with Brussels -- grow more heated.

That's despite the possibility, albeit slim, of a "no-deal Brexit" -- exiting the EU without a trade agreement in place.

The reason might be that current exchange rates -- 11 percent below pre-referendum levels -- adequately price that worst-case scenario. Or that markets are confident the worst will be averted.

But the calm may also reflect a broader shift in market psychology, increasingly evident in recent years, whereby risk is ignored until it hits traders squarely between the eyes -- the most recent example being Italy.

"No one seems to have a clue what's going to happen or even what the worst case scenario will be. In light of that the prevailing attitude is 'let's just ignore Brexit for now and focus on the Bank of England's rate hikes,'" said Markus Schomer, chief economist at PineBridge Investments.

It was expectations of BoE (Shenzhen: 000725.SZ - news) rate hikes that drove speculators' bullish sterling positions to three-year highs in February, but as policy tightening bets ebbed, positioning has returned to neutral, U.S. Commodity Futures Trading Commission data shows.

Prime Minister Theresa May's victory on Tuesday in defusing a parliamentary rebellion over the government's EU withdrawal bill did fuel a small sterling bounce. But that has already fizzled.

May's win makes a "no deal" scenario, the one most feared by markets, less likely. But it does not overcome other hurdles: agreeing what sort of Brexit deal her party wants, and then getting the nod from the EU.

Last year, the pound swung on almost every Brexit headline, but a March agreement on a 21-month post-Brexit transition may have soothed nerves.

Investors reckon markets have stopped second-guessing Brexit talks, preferring to sit on the sidelines until the crunch point for avoiding a "hard" or disorderly Brexit hits home.

As a result, levels of volatility in the pound against the dollar have almost halved since January. Against the euro volatility is well below the 2017 average.

"Markets retain a sense of "nothing is agreed until everything is agreed," said Mike Amey, head of sterling portfolios at Pimco.

The signs are that investors are not preparing for big moves. Implied volatility - a measure of expected price swings - is two-thirds of its 2018 high and is below year-ago levels.

Another derivative market positioning gauge, risk reversals, shows that demand for "call" options on the pound -- essentially a view an asset will climb in value -- has risen in recent months, compared with demand for "puts", options used to hedge against price declines.

The overall gauge has turned less negative, suggesting markets have become less concerned about a no-deal.

DOING NOTHING

Market reluctance to price Brexit scenarios in advance has echoes of other big binary events, including the Brexit referendum itself, the U.S. election outcome and the 2014 Scottish independence vote.

In all these cases, traders preferred to trade on near-term news, ignoring other possibilities until they become reality.

UK stocks too mirror the fall in Brexit sensitivity. UK stocks have bounced back and high street betting interest has dwindled -- amounts wagered in May were less than a third of January, Betfair said.

"I don't want to say markets are not rational but it feels like that's the way rational market actors are dealing with risks that they are unable to price - just assume the worst case or say let's do nothing and focus on something else," PineBridge's Schomer said.

But markets are hardly pricing the worst no-deal scenario.

Sterling has recovered half its post-referendum plunge from $1.50 to below $1.20. The rally to above $1.43 this year and the subsequent fall were driven central bank policy forecasts rather than the fortunes of Brexit talks.

Against the euro, the pound has remained range-bound between 86 pence and 89.3 pence this year.

Analysts say sterling could slide to below $1.27 and possibly through post-referendum lows of sub-$1.20 if a deal is not agreed before April 2019.

"The number of scenarios for Brexit is baffling, so many won't play the speculative trade," said ING Bank strategist Viraj Patel, noting it was hard to position for an event that's nine months away.

Jonathan Davies, head of currency strategy at UBS Asset Management, said sterling doesn't look that cheap. He estimates its pre-Brexit fair value at about $1.55 and 83 pence per euro.

"The discount that sterling is trading at relative to its "no Brexit" scenario is not that large," Davies said.

"You can't rule out the risk of something going badly wrong in the negotiations."

(Additional reporting by Sujata Rao; Graphics by Ritvik Carvalho; Editing by Toby Chopra)