The pound plunged on Thursday and was heading for its biggest one-day fall this year on growing fears of a "no-deal" Brexit should British lawmakers hold firm in their rejection of Prime Minister Theresa May's EU divorce deal.
While a broad-based rally in the dollar also weighed on the pound, traders said the risks of a no-deal Brexit have grown in the last 48 hours, sending the British currency falling across the board and kicking bond yields lower.
"A dollar rally and a broad unwinding of long sterling positions across the board after the recent rally is weighing on the pound as the various Brexit positions become more polarized," said Neil Jones, head of hedge fund currency sales at MUFG based in London.
Sterling tumbled 1.3 percent to $1.3004, its biggest daily drop since December 2018. It has fallen nearly 3 percent from a nine-month high of near $1.34 hit last week.
It also weakened 0.8 percent to 87.15 pence against the euro.
May has asked European Union leaders to delay Brexit from March 29 until the end of June and said she was preparing for a third vote in the British parliament on the exit deal she arduously negotiated with Brussels.
While German Chancellor Angela Merkel has voiced readiness to back a short extension, traders are increasingly worried that, if the deal is voted down for a third time in parliament, a host of possibilities open up, none of which are positive for the pound in the short term.
"We could still stumble into a no-deal Brexit," said John Marley at FX risk management specialist, Smart Currency Business based in London.
While banks' assessments of the probability of a no-deal Brexit remain low and have not changed in recent days - Berenberg, for example, see it at a slim 15 percent - increased signs of unease are showing up in currency derivative markets.
Risk reversals in the pound maturing in two weeks fell to their lowest levels since mid-December. This is measures demand as a ratio of call to put options; puts offering the right to sell at a certain price, and calls - the right to buy.
Risk reversals maturing over one to three months registered bigger declines, falling to their lowest levels since November.
"Sterling continues to be volatile, pushed and pulled around as the news unfolds," UBS Wealth Management told clients.
"For now, we do not advocate taking directional views on the currency, but we remain alert to entry and exit opportunities if volatility persists."
In a sign of how much focus there is on Brexit headlines, an unexpected rise in retail sales data in February failed to elicit any meaningful reaction from the pound.
Another source of support for sterling - expectations of an interest rate rise by the Bank of England - is also ebbing. The bank had been expected to raise rates once Britain exited the EU with a deal and transition period in place, but could be forced to ease policy instead in the event of a no-deal outcome.
A market-implied gauge of rate hikes from the Bank of England indicates the possibility of a rate rise by December has dwindled to 18 percent, compared to 40 percent earlier this week. The Bank of England kept interest rates steady on Thursday and said most businesses felt as ready as they could be for a no-deal Brexit.
Rabobank strategists said the BoE's hands were broadly tied for now, given the ongoing Brexit negotiations.
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