By Saikat Chatterjee and Tommy Wilkes
LONDON (Reuters) - Investors in short-dated sterling bonds could be the main winners if Britain and the European Union fail to hammer out the contours of a Brexit transition deal at a summit starting on March 22.
For foreign holders of UK debt, though, the risks of a slide in sterling because of stalled Brexit talks could outweigh any fixed-income gains, especially as some investors also view the pound as overvalued and vulnerable to a rise in protectionism.
At the start of January, bets on a UK rate rise in May were close to zero but futures markets are now pricing in a 70 percent chance of an increase after the Bank of England (BoE) adopted a more hawkish stance at its February policy meeting.
The shift in the bank's economic outlook, however, was partly conditional on London and Brussels agreeing a transition deal in March to smooth the path to Brexit, rather than letting the negotiations drag on until a summit at the end of June.
"I would be very surprised if we got enough from both sides to piece together a deal by the March summit and therefore we like the UK curve because most of the BoE hawkish rhetoric is already priced in by the bond markets," said Jason Simpson, UK rates strategist at Societe Generale.
Because financial markets expect an imminent increase in the Bank of England's base rate, bond yields at the shorter end of the yield curve have risen quickly.
The UK yield curve has flattened considerably since late January thanks to the rise in interest rate bets. Yields on securities with maturities up to five years have risen 20 to 35 basis points while 10-year yields are up 7 basis points.
Over the last month, the spread between two-year and 10-year British gilt yields has narrowed by 30 basis points. That compares with a tightening of 11 to 13 basis points in the U.S. and German bond yield curves.
But if the likelihood of a so-called soft Brexit fades and bets on higher UK rates in May don't pan out, that would attract buyers to the short end of the bond market hoping to benefit from price rises as yields drop back.
At the moment, sterling is riding high. It hit $1.4346 on Jan. 25, its highest level against the U.S. dollar since Britain voted to leave the European Union in June 2016.
The UK currency has since weakened to $1.39 but remains near the top of its trading range of $1.20 to $1.43 since the Brexit referendum, buoyed by hopes a transition deal will be eventually be struck and a generally weaker U.S. currency.
Doubts are creeping in. By last week, investors had slashed net bets that sterling will rise by more than 80 percent from a three-year high in late-January, according to Reuters calculations and Commodity Futures Trading Commission data.
But some investors think sterling, which has risen 1 percent this month against the dollar, is still underpricing the risk of a delayed transition deal, less than a year before Britain is officially due to leave the European Union.
"I am short on sterling as markets were too positive before Brexit negotiations began a couple of weeks ago and as we can see there are more frictions in the discussions," said Andreas Koenig, head of foreign exchange at Amundi Asset Management, which manages 1.4 trillion euros ($1.7 trillion) in assets.
In the last two weeks, the gap between British and EU officials has re-emerged as a major threat to the currency. The two sides appear as far apart as ever on how to keep Northern Ireland's border open and Brussels has snubbed London's desire for any trade deal to cover financial services.
On Tuesday, Michel Barnier, the European Union's Brexit negotiator said Britain would not retain its current privileges, including on trade, once it leaves the bloc.
"We think there is a lot of uncertainty around the March summit, which investors are not prepared for and as a result we are recommending a short sterling position," said Michael Sneyd, head of global currency strategy at BNP Paribas, who expects sterling to weaken to 92 pence against the euro.
On Tuesday, it was changing hands at 88.5 pence .
UBS strategists argue that even if the Bank of England does stick to raising interest rates it would prove ineffective in supporting sterling as the currency is heavily overpriced.
It estimates sterling is overvalued by as much as 25 percent and the UK's current account deficit at 4.5 percent of gross domestic product is far higher than historical averages.
HARD BREXIT FEARS
The ground is also shifting globally. With fears of a trade war growing, Britain's open economy could find itself badly hit, especially if a hard Brexit leaves it without the support of EU trade negotiators.
Analysts say the United Kingdom's twin fiscal and current deficits would leave the country, and sterling, vulnerable should trade protectionism escalate.
U.S. President Donald Trump raised fears of a global trade war by slapping tariffs on U.S. steel and aluminum imports. Major trading partners have threatened to retaliate and Trump's move has cast a shadow over U.S. negotiations with Canada and Mexico about renewing their North American trade deal.
An analysis by Bank of America Merrill Lynch of client flows on its trading platforms shows that of the major G10 currencies, the Canadian dollar and sterling have been sold the most over a four-week period.
Beyond the crucial EU summit in March, fears about the failure of Brexit talks altogether are growing, making some investors even more jittery about sterling.
While the consensus is that the likelihood of a disorderly British exit from the EU remains at 20 percent - roughly where it has been all year - several economists polled by Reuters said it had increased over the past week.
Kallum Pickering, an economist at Berenberg Economics, has raised his expectation of a "hard Brexit", under which Britain leaves the EU without securing a trade deal, to 25 percent from 20 percent.
Amundi's Koenig reckons that in such a scenario, sterling could fall 5 percent from current levels and others are even gloomier. Cesar Perez Ruiz, chief investment officer at Pictet Wealth Management, predicted sterling could crash to $1.20 and to parity with the euro.
(Reporting by Saikat Chatterjee and Tommy Wilkes; Additional reporting by Dhara Ranasinghe and Andy Bruce; Graphics by Ritvik Carvalho; Editing by David Clarke)