The pound on Wednesday gave back some of the previous day's gains as investors took little heart from hints by German Chancellor Angela Merkel that there might be room for negotiation over Brexit as prospects of a no deal loom.
British Prime Minister Boris Johnson is due to meet Merkel on Wednesday ahead of a G7 meeting and is expected to tell her that unless she agrees to changes, Britain will leave the European Union on Oct. 31 without a transitional agreement.
Merkel said on Tuesday that she was open to "practical solutions" to the Irish backstop - or border insurance policy - which Johnson says is unacceptable but that the Withdrawal Agreement was not to be reopened. That helped lift the pound to a two-week high.
Merkel also said on Wednesday she would discuss with Johnson - who is due to meet French President Emmanuel Macron on Thursday - how to make sure Britain's divorce was smooth as possible.
The pound was down 0.4% at $1.2118, retreating from the 12-day high of $1.2180 reached on Tuesday. It remains up 0.8% from mid-August lows. Against the euro, sterling was also down 0.4%, at 91.56 pence, but similarly up 1.8% since mid-August.
With Brussels looking unwilling to budge on the Irish backstop, MUFG currency analyst Lee Hardman said a no-deal Brexit looked on the cards unless there was a last-minute compromise or a change of government in Britain.
"As a result, we continue to believe that the risks for the pound are skewed to the downside even as the market has moved a long way in recent months to price in no-deal Brexit risk," Hardman said.
Based on prices in the derivatives market and investor positioning, market participants continue to expect the pound to weaken, albeit less than a week ago. Some are remaining neutral on the pound until some clarity over on what terms - or indeed whether - the bloc's second largest economy will leave the club it joined in 1973.
"Our position in sterling is flat," said Adrian Owens, portfolio manager at GAM Investments.
Some are waiting for the currency to fall even further before potentially considering buying it. Sterling has shed 9% and 7% of its value against the dollar and the euro respectively since spring.
"Potentially, we could look to dip our toes into sterling if it becomes more cheaper but that depends again on how Brexit probabilities shift. We are neutral on gilts, equities and the currency now," said Justin Onuekwusi, fund manager at Legal and General Investment Management.
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