Pound slumps as return of hard Brexit fears rattles investors

By Saikat Chatterjee and Dhara Ranasinghe

LONDON (Reuters) - Britain's pound tumbled on Tuesday, erasing its post-election gains, after news that Prime Minister Boris Johnson planned to take a hard line in Brexit talks with the European Union dashed hopes of an end to Brexit uncertainty.

The British currency was on course for its biggest one-day loss versus the U.S. dollar since November 2018.

In his boldest move since winning a large majority in last Thursday's election, Johnson will use the prospect of a Brexit cliff-edge at the end of 2020 to demand the EU give him a comprehensive free trade deal in less than 11 months.

The reaction in markets, which had hoped that a resounding election win for Johnson's Conservative Party would end near-term Brexit uncertainty, was swift.

Sterling slumped as much as 1.5% to $1.3127 <GBP=D3>, giving up all of the gains made on Thursday and Friday after it became clear that the Conservative Party was heading for a big win.

Against the euro, the pound tumbled 1.6% to 84.99 pence <EURGBP=D3>, having skyrocketed to a 3-1/2-year high of 82.78 pence last week.

"We have been warning against getting too optimistic on the pound in the run-up to the UK election and now that the contest is over we are turning negative on sterling again," said George Saravelos, global head of FX research at Deutsche Bank.

He said that while a disorderly Brexit was not "inevitable," it raised the bar for compromise and sent a negative message to business about the economy.

After Britain leaves the EU on Jan. 31, it enters a transition period in which it remains an EU member in all but name while both sides try to strike an agreement on their post-Brexit relationship.

Currency analysts said that markets did not appear to be pricing in increased chances of a hard Brexit, but the post-election Brexit optimism was over.

Some investors had thought that Johnson would use his majority in Parliament to adopt a more moderate approach towards Brexit negotiations.

They now rushed for protection against unexpected swings in the pound, pushing option prices up.

As a result, this sent implied volatility gauges with longer-dated maturities to their highest levels since Friday. <GBP6MO=FN> <GBP9MO=FN> <GBP1YO=FN>

Graphic - Pound risk reversals: https://fingfx.thomsonreuters.com/gfx/mkt/12/10096/10007/Pound%20risk%20reversals.png

"I don't think risks are skewed towards hard Brexit pricing at this stage because the end of the transition period is still over a year away," said Jordan Rochester, a currency strategist at Nomura.

"This is something that will start to become more relevant from February onwards when the trade talks get under way and will likely come to a head in June, when there's a summit with the EU and that's when we have to decide whether to extend."

Analysts say a comprehensive trade deal with the EU could take years, not months, to negotiate.

They added that for sterling, the economy's prospects could play a greater role - starting with Thursday's Bank of England policy meeting.

British factory output fell at the fastest pace in more than 10 years during the three months leading up to Johnson's election victory, a survey on Tuesday showed, underscoring the economic challenge he faces.

(Reporting by Saikat Chatterjee, Dhara Ranasinghe and Olga Cotega in London; Editing by Giles Elgood and Matthew Lewis)