Merkel told British Prime Minister Boris Johnson that a deal was doomed to fail unless London agreed to keep British-run Northern Ireland that borders EU-member Ireland in the bloc's customs union, a Downing Street source was quoted as saying.
The host of next week's European summit, EU Council president Donald Tusk, in turn blasted British Prime Minister Boris Johnson of trying to shift blame for the failure of the Brexit talks.
In late morning deals, the European single currency advanced as high as 89.94 pence, while the pound dived as low as $1.2226.
In another blow, the host of next week's European summit, EU Council president Donald Tusk, accused Johnson of trying to play a Brexit "blame game" over Britain's looming EU departure on October 31.
'Greater chance of no-deal'
"Markets are having to focus on the various potential outcomes which are now imminent," Interactive Investor analyst Rebecca O'Keeffe told AFP.
"A deal looks very unlikely unless the EU blinks first."
She added: "For many, the word of the PM is government policy, hence the global market is moving towards pricing in an ever greater chance of a no-deal."
Losses were exacerbated by official data showing that British productivity tumbled at its fastest rate in five years in the second quarter of 2019.
European stock markets meanwhile took a sharp turn lower, with Frankfurt shedding one percent and Paris losing 0.9 percent, on growing investor doubts over this week's China-US trade talks.
London stocks however dropped just 0.2 percent with losses capped by the weak pound, which boosts multinationals earning in stronger currencies.
Investors were waiting for the resumption of China-US trade talks this week, though hopes for success are being tempered by mixed messages from both sides.
There has been some general, positive feeling in recent weeks that a solution to the long-running tariffs saga can be found, providing some much-needed support to equities in the face of worsening economic data.
Trade talks
Beijing's top trade envoy Liu He is due to meet US Trade Representative Robert Lighthizer and Treasury Secretary Steven Mnuchin on Thursday.
Observers warn it is unlikely progress will be smooth, with reports this week saying China had cut back on the number of areas it is willing to discuss, suggesting leaders sense weakness in the White House as Donald Trump faces impeachment proceedings and a slowing economy.
Trump said late Monday he preferred to strike a big deal. "We've come this far. We're doing well. I would much prefer a big deal and I think that's what we're shooting for," he told reporters.
Separately, the US said it was blacklisting 28 Chinese entities it accuses of being implicated in rights violations and abuses targeting Uighurs and other mostly Muslim minorities in the Xinjiang region. The move bars them from buying US products.
The trade meeting comes just over a week before a new round of punitive tariffs is due to be imposed on China.
Key figures around 1100 GMT
Pound/dollar: DOWN at $1.2233 from $1.2293 at 2100 GMT
Euro/pound: UP at 89.88 pence from 89.25 pence
Euro/dollar: UP at $1.0995 from $1.0971
Dollar/yen: DOWN at 106.93 yen from 107.26 yen
London - FTSE 100: DOWN 0.2 percent at 7,187.41 points
Paris - CAC 40: DOWN 0.9 percent at 5,472.81
Frankfurt - DAX 30: DOWN 1.0 percent at 11,980.40
EURO STOXX 50: DOWN 0.9 percent at 3,440.17
Tokyo - Nikkei 225: UP 1.0 percent at 21,587.78 (close)
Hong Kong - Hang Seng: UP 0.3 percent at 25,893.40 (close)
Shanghai - Composite: UP 0.3 percent at 2,913.67 (close)
New York - Dow: DOWN 0.4 percent at 26,478.02 (close)
Brent North Sea crude: DOWN 0.5 percent at $58.09 per barrel
West Texas Intermediate: DOWN 0.6 percent at $52.41 per barrel