The pound fell on Friday after enjoying its biggest one-day gain in months, as investors reassessed whether British Prime Minister Boris Johnson had made any progress in convincing the European Union to renegotiate the Brexit agreement. German Chancellor Angela Merkel's comments on Thursday that a solution to the Irish border question could be found before Oct. 31, the deadline for Britain to leave the EU, triggered the pound's biggest one-day rise against the dollar since May. Against the euro, sterling gained the most in five months.
But many analysts said the reaction to Merkel's comments reflected market positioning rather than any confidence Britain and the EU would be able to renegotiate their agreement to avoid a no-deal Brexit. "The market is very short and that is naturally going to make the market very sensitive to any news (that makes them think) ... have we got this wrong?," said Jane Foley, a strategist at Rabobank. "I've not read an awful lot into these moves," she said, adding that thin summer liquidity had exacerbated this week's volatility.
Kamal Sharma, G10 forex strategist at Bank of America Merrill Lynch, said the market had "over-interpreted" Merkel's comments. BAML took off its last remaining sterling position before the move on Thursday, and Sharma said the bank prefers to trade sterling volatility instead because "the range of (Brexit) options and possibilities are quite big".
The British currency fell as much as 0.5% to $1.2195 on Friday, retreating from Thursday's three-week high. It later rebounded slightly, trading 0.2% lower at $1.2235 by 1430 GMT. Versus the euro the pound dropped as low as 90.80 pence before recovering to 90.53 pence, down 0.1%.
Sterling has fallen since Boris Johnson became prime minister in late July. Investors fear his government will take Britain out of the EU in October without a transition deal. Most economists think a no-deal Brexit would deliver a significant blow to the British economy and cause a further rout in the pound - sending it towards parity with the euro and below $1.20 - as international investors dump the currency.
Many banks have raised their forecasts for a no-deal exit since Johnson took office, although analysts say that the consensus among most banks is that Britain will still avoid a no-deal Brexit.
That may be changing, however. Barclays economists this week said a no-deal Brexit was now "the most likely outcome" and "our new working assumption". They also said that the British government's tactics, including by undermining potential negotiations with the EU, had increased the risk Brussels did not grant an extension to Brexit if London requested one.