Pound gains on court ruling but Brexit uncertainty clouds outlook

By Olga Cotaga and Tommy Wilkes

LONDON (Reuters) - Sterling gained on Tuesday after a British court ruled against the prime minister but market players saw no signs of a sustainable rebound in UK assets and said the events further deepened the uncertainty investors now attach to the currency.

The Supreme Court's decision, which called Prime Minister Boris Johnson's suspension of parliament unlawful and said lawmakers should return to sitting, is widely seen as reducing the probability of Britain leaving the European Union without a divorce agreement on Oct. 31.

But some traders said it was virtually impossible to predict where things were headed.

Johnson was defiant after the ruling and vowed that Britain would leave the EU by Oct. 31, come what may.

"With both the Tory and Labour electorate fragmented around the deal and no deal issue, the UK is running the risk of turning into an 'Italy-like' disaster," said Artur Baluszynski, head of research at Henderson Rowe, referring to Italy's reputation for political instability and regular elections.

After the court ruling, the British currency strengthened as much as 0.6% to $1.2504 , having hit $1.2582 last week. Against the euro, sterling rose by 0.4% to 88.075 pence .

Fund managers have previously said the pound has behaved more like an emerging market currency since the 2016 Brexit referendum, with significantly higher volatility than developed peers and big moves on unpredictable political events.

Such perceptions are damaging for an economy whose competitiveness is based on a stable, predictable political system and strong institutions, many investors say.

Stephen Gallo, European head of FX strategy at BMO Capital Markets, said sterling looked "untradable" for the time being.

"Our base case is still that new elections will take place sooner rather than later, but we are clueless as to what path UK politics will take in order to bring us there. The same holds for Brexit," Gallo said.

The pound has rallied this month from a three-year low of below $1.20, but faltered as doubts return about what happens next. Most investors agreed the court's decision made it harder for Johnson to suspend parliament again, helping the currency push higher.

British bond yields rose after the ruling, then slipped back to around flat. London's blue-chip share index <.FTSE> fell.5%, but a JPMorgan index tracking companies <.JPDEUKDM> that get most of their revenues in Britain rose 0.4%.

VOLATILITY

UBS Wealth Management was among those who reckon the court decision has further reduced immediate risks of no-deal Brexit.

"We still see upside for the pound and are overweight it versus the U.S. dollar in our FX strategy," they told clients.

(Graphic: Sterling volatile, https://fingfx.thomsonreuters.com/gfx/mkt/12/6487/6418/gbp.png)

EXTRA TIME

Lawmakers will return to Westminster on Wednesday and more turmoil is likely, with opposition leader Jeremy Corbyn pledging to hold Johnson to account. Johnson says the parliament suspension - from Sept. 10 until Oct. 14 - was to allow the government to bring in a new legislative agenda.

"Today's events mean that an election is now more likely than ever," said Baluszynski at Henderson Rowe.

Three years of Brexit twists and turns have made it hard to profit from trading the pound, and many traders have instead turned to betting on more volatility.

Nervous investors are buying protection against unexpected moves in sterling, sending one-month implied volatility gauges -- which span the deadline for Johnson to find a Brexit deal -- to a three-week high .

The gauge slipped after the ruling.

(Graphic: Sterling one month vol dips, https://fingfx.thomsonreuters.com/gfx/mkt/12/6486/6417/gbpvol.png)

The pound could slide toward parity against the euro - and even the dollar - in the event of a no-deal Brexit, according to many analysts. If fears of that event recede further, the pound could firm more but the fog of various election and Brexit scenarios in the months ahead are likely to cap gains.

Adam Cole at RBC Capital Markets said Tuesday's rise in the pound meant the risk of a no-deal Brexit was possibly underpriced, especially if no agreement was found even after the three-month extension lawmakers want.

"Sterling is a tactical sell into today's rally," he added.

(Additional reporting by Tommy Wilkes and Josephine Mason; Editing by Alison Williams)

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