The pound erased early gains and fell against the dollar on Wednesday, as investors refocused their attention towards Brexit talks and European policymakers warned Britain could crash out of the European Union without a trade deal in place by the end of 2020.
Sterling's weakness came despite riskier assets recouping earlier losses on some hopes that Iran's missile strikes on US forces in Iraq would not lead to a wider regional conflict.
Iran said it had fired 15 missiles at US targets in Iraq early on Wednesday in retaliation for last week's US drone strike that killed Iranian commander General Qassem Soleimani, stoking fears of a new war in the Middle East.
US President Donald Trump said no-one was killed in the strikes and that Iran appeared to be standing down.
Though the Japanese yen initially gained and global stocks tumbled after the attacks, market fears faded on some hopes the raid would not lead to an immediate military escalation, pushing riskier assets including the pound higher.
But those gains proved to be short-lived as investors resumed selling the pound near $1.32 levels against the dollar.
Sterling was last trading down 0.2% at $1.3088, further away from its December high above $1.35. Against the euro, the pound was flat at 84.91 pence.
"If the US-Iran situation calms, as it looks like it might, then focus will return to Boris Johnson's meeting with the European policymakers and the tone of any comments that will follow," said John Marley, a senior FX consultant at FX risk management specialist SmartCurrencyBusiness.
Britain is due to leave the bloc on Jan. 31 and the sides will then have until the end of the year to negotiate a new trade relationship - a short period given the complexity of the discussions. Ursula von der Leyen, the head of the European Commission said on Wednesday that it would be "basically impossible" to negotiate all aspects of the future relationship between the EU and Britain by the end of this year.
A hard Brexit at the end of 2020 remains a possibility and could cut deep into foreign trade, European Central Bank policymaker Klaas Knot said on Wednesday. But British Prime Minister Boris Johnson insists that he will not ask for an extension to the transition period beyond 2020.
"With Johnson reluctant to pursue any more delays, there is a clear risk of the process resulting in a no-deal Brexit at the end of the year, the threat of which is likely to limit any upside in the pound," said Phil McHugh, Chief Market Analyst at Currencies Direct.
Despite the volatile start to the week, pound bulls remained stubborn after Prime Minister Boris Johnson's Conservative Party won an 80-seat lower house majority in last month's election. Investors have increased their pound holdings with net long positions in the currency at their highest levels in more than 1-1/2 years, according to the latest positioning data.
Derivative markets also suggest more upside for the pound with risk reversals - a ratio of call options to put options - for one-month maturities at their highest levels in nearly two months.
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