Sterling gave up some of last week's strong gains on Monday after the European Union and Britain said a lot more work would be needed to secure an agreement on the country's departure from the bloc by Oct. 31.
The pound briefly fell more than 1% to a session low of $1.2517 in a choppy London session. Against the euro, the British currency weakened by a similar margin to 88.11 pence.
By late London trading, the pound was down 0.5% against the dollar and the euro, at $1.2585 and 87.59 pence respectively.
A Brexit deal was hanging in the balance on Monday after diplomats indicated that the bloc wanted more concessions from British Prime Minister Boris Johnson and a full agreement was unlikely this week.
"Don't take a Brexit deal for granted and the bigger risk here is what concessions will be made from either side," said Neil Mellor, a senior currency strategist at BNY Mellon.
Though the mood music for the pound's short-term outlook has improved considerably over the past week, market watchers, including UBS, warned that there were still hurdles in the way of Britain and the EU agreeing a deal.
What compromises each may be prepared to make will be key, with too many concessions by the EU potentially compromising the integrity of the single market and the British side hampered by internal political obstacles, UBS said.
"With time tight and much ground to cover we still, on balance, believe that the UK will be asking for a further extension to Article 50," said Dean Turner, an economist at the Swiss bank.
Sterling rocketed at the end of last week, posting its biggest two-day gain for several years, after Britain and the EU announced the surprise resumption of talks to agree a withdrawal arrangement before the scheduled Oct. 31 Brexit date.
Britain said on Sunday the latest talks had been constructive and there would be more talks on Monday.
Reflecting the uncertainty, gauges of volatility for short-term sterling instruments soared, with one-week maturities trading above 16 vol, more than double last week's reading and close to its highest level this year.
The rise in expected volatility has inverted the term structure for expected price swings in the pound to its most extreme levels this year, with shorter-dated volatility rising more than volatility gauges in longer-maturities as traders brace for more short-term Brexit news.
The latest positioning data showed a further unwinding of extreme short positions though they still remain large by historical averages, indicating that any news of a Brexit deal could squeeze the pound sharply higher.
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