LONDON: Positive signals from London and Brussels over the trade component of EU divorce talks drove sterling higher against the euro on Thursday, though the risk of a no-deal Brexit kept the British currency well off 2018 highs.

The pound hit a one-week high against the euro, extending overnight gains and heading for its biggest two-day rise since November after the bloc's chief negotiator said on Wednesday it was ready to offer Britain an unprecedentedly close relationship after it quits.

But Michel Barnier tempered those comments on Thursday, saying on German radio that the European Union must also prepare for the possibility of a no-deal Brexit.

"Barnier's comments are more nuanced and that has prompted a slight positioning switch towards sterling rather than a broader fundamental change towards the currency's outlook," said Neil Mellor, a senior currency strategist at BNY Mellon In London.

Trading in the pound remains underpinned by the no-deal scenario and, despite this week's run which took it as high as 89.73 pence per euro on Thursday, the currency remains well off its year-to-date high of 86.2 hit in April.

Barnier's comments did not depart significantly from his previous position on Brexit.

EU diplomats said his aim was to talk up the trade deal in order to entice Britain into accepting it and an Irish border emergency plan - a key sticking point in Brexit talks.

"Barnier is working for a deal, he talks trade to get the Irish backstop through," a senior EU diplomat said.

Britain's Brexit minister, Dominic Raab, is due to meet in Brussels on Friday with Barnier in a bid to pick up the pace of Brexit talks

With seven months to go until Britain leaves, its government has been ramping up its no-deal preparations, and negotiators on both sides increasingly expect an informal October deadline for reaching an agreement to slip into November.

Raab told on Wednesday that, while a deal was within sight, there was "a measure of leeway" over the exact timetable.

As the political outlook over Brexit has clouded, hedge funds have in recent weeks built short positions against the pound to more than one-year highs, meaning any slight change in sentiment towards the currency can lead to big moves.

This week, implied market volatility on the British currency has also risen more than its counterparts in the euro and the Japanese yen.

For sterling bears finding it increasingly expensive to fund these short bets, some traders said Barnier's comments - indicating a slightly more conciliatory tone rather than a major shift in negotiating stance - were the final straw.

"Higher sterling volatility means more difficulty in holding short positions and the latest headlines are leading to a wipeout in some of those aggressive shorts," said a trader at a European bank.

The latest developments have also prompted derivative traders to cut their long euro/sterling bets, having ramped up their positions by building some large option bets around the 91-pence level.

"An agreement (on trade) by the year-end is more likely than not and more encouraging Brexit headlines could see leveraged funds further bail on their recently built short sterling positions," ING strategists said in a note.

Against the dollar, the British currency's gains were a bit more muted as it settled near a one-month high around $1.3024.