By Mike Dolan
LONDON (Reuters) - Keeping the status quo may well be what the British government wants after its June 23 referendum on European Union membership, but a sigh of relief in the financial world could bring its own short-term economic policy headaches.
With a month to go to the referendum, the economic and financial risks of 'Brexit' dominate headlines from the Treasury, Bank of England, International Monetary Fund and Group of Seven economic powers.
All argue vociferously that leaving the EU would be a negative shock for the world's fifth largest economy.
Yet for all the angst about a falling pound and foreign investment hiatus, the most likely scenario is a vote to remain and, with that, the chance of a sterling surge that policymakers and company bosses will have to contend with over the summer.
Neck-and-neck for months, opinion polls over the past two weeks have started to break selectively against the Brexit camp. Bookmaker odds, which rarely wavered this year showing 'Remain' as the most likely outcome, have lengthened on an exit even further and now show only a 20 percent chance of a vote to go.
But while exchange rate strength may pale in comparison to the uncertainty of reshaping Britain's dominant trade, economic and political relationship, few countries would openly embrace a currency surge right now as they battle for razor-thin advantages in a slowing global economy.
So how likely is it that sterling rallies hard after a vote to stay in the EU?
The pound lost up to 10 percent of its value on a trade-weighted basis <=GBP> against major currencies over the past six months as Brexit anxiety jarred and measures of implied volatility in the options market soared - reflecting demand to insure against wild swings in the currency around the vote.
While it's bounced about 5 percent since April, implied volatilities are still almost twice where they were two years ago and the clear bias in options pricing remains substantially skewed to puts, or options to sell, over the coming months.
So, on the face of it, at least, there is still substantial bearishness embedded in the pound pricing - a large chunk of which would presumably dissipate on a status quo EU vote.
And Reuters consensus polls show sterling could add 4-5 percent more if Brexit is avoided. But at the margins, some punters have already eyed gains against the dollar of almost 20 cents, up to 14 percent above current rates, with options triggers or 'strikes' as high as $1.65 on the day after the poll.
VOTE SQUEEZE
Moves of that scale would either come about by a sudden squeeze on short pound positions that forces traders to hoover up sterling to close out loss-making trades - or by more fundamental re-assessment of sterling assets more broadly.
Although net "short" sterling positions have eased back of late, data reported by the Chicago-based Commodity Futures Trading Commission show the numbers of short pound contracts still close to their highest in three years.
What's more, UBS investment bank's proprietary data shows cumulative sterling outflows over the past year are not even close to being reversed despite some easing in pound selling this month. Only speculative hedge funds have been flirting with buying the pound lately - asset managers, non-financial firms and private clients remain well clear of sterling, it shows.
That suggests there may well be a long-term return to sterling assets to underpin any speculative fillip.
One argument is that overseas investors, critical to funding the UK's whopping current account deficit, have simply been buying fewer sterling assets than they would otherwise have accumulated in the absence of this outsize political risk.
And arguably they have 'under-owned' Britain plc since before the referendum on Scottish secession in September 2014, through last May's election of the Conservative Party majority government and on to next month's Brexit vote that it pledged.
May's Bank of America (NYSE:BAC) Merrill Lynch's survey of some 205 money managers worldwide, with a collective $619 billion of assets under management, showed holdings of UK equities had been cut back to their lowest level since November 2008.
And yet despite obvious caution towards UK equity, fuelled partly by the heavy weighting in UK indices of battered energy and mining stocks, fully 71 percent of the funds polled said they still thought Brexit was unlikely and a net 20 percent thought sterling was now undervalued.
The UK bond picture - which has been complicated by the ebb and flow of UK interest rate rise speculation over the past couple of years - is perhaps less stark. But here too, data from the UK Debt Management Office shows the share of overseas holdings of gilts has fallen 2 percentage points to just over 27 percent since the start of 2014.
Yet cross-currents abound, as always.
Even if a combined stock and bond return and speculative currency market unwind did supercharge the pound initially - there's every chance it undermines its own durability.
While clearing the decks of Brexit risks may rekindle talk of Bank of England interest rate rises and lift the pound, damage to growth and inflation from a significantly higher sterling may well actually tie BoE hands.
And one reason for a return to UK equity could be snuffed out if the sterling jump were to hit UK companies with heavy overseas earnings. Gilts would fear a rate rise, but lap up sterling strength.
Foggy for sure. But on the assumption the most likely referendum outcome does emerge, the talk of the summer may well revert to just how much sterling strength Britain can take.