British cabinet ministers are deadlocked over a future deal with the block and the Telegraph newspaper said Britain would tell Brussels it was prepared to stay in the customs union beyond 2021, sending the pound to a two-day high.

Sterling later relinquished most of its gains however. Prime Minister Theresa May denied she was "climbing down" from her position and said Britain would be leaving the EU customs union as she has previously outlined.

At GMT 0820 sterling was up 0.2 percent at $1.3525 and traded up 0.1 percent versus the euro at 87.37 pence , close to a three-week high of 87.15 hit earlier in the session.

The pound's jump suggests the currency remains vulnerable to Brexit negotiations that have dominated British politics since a 2016 referendum, even as Britain's economy has shown signs of strengthening.

" again proves that sterling benefits the closer the Brexit scenario under discussion resembles the status quo," said Esther Maria Reichelt, an FX strategist at Commerzbank in Frankfurt.

Riechelt said that the risk of a hard brexit remained, though, and that the pound could face downward pressure because the EU would likely meet the proposal with scepticism.

Britain is due to leave the EU in March next year although it has secured a transitional arrangement to keep its trade ties with the bloc unchanged until the end of 2020, as long as a permanent deal can also be reached in the coming months.

Cabinet ministers have discussed keeping the UK tied to EU customs rules for longer as a way of avoiding a hard Irish border.

Other analysts downplayed the importance of the customs union discussions for the pound.

"I wasn't particularly excited about the news since most investors have been expecting a customs union change for a while," said Jordan Rochester, FX strategist at Nomura.

He said that data on the UK economy and the Bank of England's path for monetary tightening would dictate the fortunes of the currency.