Positive signals from London and Brussels over the trade component of Britain's EU divorce talks drove sterling higher against the euro on Thursday, though the risk of a no-deal Brexit kept the pound well off 2018 highs.
Sterling hit a one-week high against the euro and was heading for its biggest two-day rise since November after EU negotiator Michel Barnier said on Wednesday that the bloc was ready to offer Britain an unprecedentedly close relationship after it leaves.
Barnier tempered those comments on Thursday, telling German radio that the European Union must also prepare for the possibility of Britain leaving without concluding any deal.
"Barnier's comments are more nuanced and that has prompted a slight positioning switch towards sterling rather than a broader fundamental change towards the currency's outlook," said Neil Mellor, a senior currency strategist at BNY Mellon In London.
Despite this week's run which took sterling as high as 89.93 pence per euro on Thursday, the currency remains well off its year-to-date high of 86.2 hit in April.
Barnier's comments did not depart significantly from his previous position on Brexit. EU diplomats said his aim was to talk up the trade deal in order to entice Britain into accepting it and an Irish border emergency plan known as the backstop, a sticking point in the Brexit talks.
"Barnier is working for a deal, he talks trade to get the Irish backstop through," a senior EU diplomat said.
British Brexit minister Dominic Raab is due to meet Barnier in Brussels on Friday in an attempt to speed up the talks.
With seven months to go until Britain leaves, the government has been ramping up its no-deal preparations, and negotiators on both sides increasingly expect an informal October deadline for reaching an agreement to slip into November.
Raab said on Wednesday that, while a deal was within sight, there was "a measure of leeway" over the exact timetable.
Foreigners' net holdings of British government debt fell by a record amount last month, a move partly driven by a large volume of maturing bonds but one which also revived concerns about the effect of Brexit on investors' appetite.
Bank of England data showed a net 17.153 billion pound ($22.3 billion) drop in foreigners' holdings in July, the largest since records began in 1982.
As the political outlook over Brexit has clouded, hedge funds have built short positions in recent weeks against the pound to more than one-year highs.
That means any slight change in sentiment towards the currency can lead to big moves.
For sterling bears finding it increasingly expensive to fund these short bets, some traders said Barnier's comments - indicating a slightly more conciliatory tone rather than a major shift in negotiating stance - were the final straw.
"Higher sterling volatility means more difficulty in holding short positions and the latest headlines are leading to a wipeout in some of those aggressive shorts," said a trader at a European bank.
The latest developments have also prompted derivative traders to cut their long euro/sterling bets, having ramped up their positions by building some large option bets around the 91-pence level.
Against the dollar, the British currency fell 0.3 percent and traded close to the $1.3 level.
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