The pound held gains even as key economic data came in weaker than expected, as the market opted to focus instead on signs of progress in Brexit talks.
The currency strengthened on Monday following a Sunday Times report that Prime Minister Theresa May has secured concessions from Brussels to let her keep all of Britain in a customs union with the European Union. The currency stayed higher even after a report showed the services sector slowed in October.
Sterling could "blast through" $1.35 within two days if a divorce is agreed between Britain and the bloc, according to Mizuho Bank.
The UK currency may recoup about half of its more than 10% decline from pre-Brexit vote levels if there is a divorce deal, according to a Bloomberg survey last month. Trader positioning on the currency is heavily short as missed deadlines in negotiations have increased concern in recent months that there may be no deal.
"Brexit deal optimism remains the flavour of the month, even ‘trumping’ the market’s love for the dollar," said Stuart Bennett, head of Group-of-10 currency strategy at Banco Santander SA. "The consensus is that a deal will be reached, maybe this month or early December, and so positioning is adjusting."
Sterling was 0.3% stronger at $1.3011, after earlier rallying as much as 0.7%. The currency advanced 0.3% to 87.51 pence per euro. The yield on UK 10-year government bonds climbed two basis points to 1.51%.
IHS Markit’s index for the UK services sector fell more than economists expected last month, recording the lowest reading since March. The gauge fell to 52.2 in October, down from 53.9 the previous month and below the 53.3 forecast by economists.
The chances of reaching an agreement with the EU appear to be improving, with the Prime Minister’s de facto deputy David Lidington saying Friday that the two sides are "certainly very close to resolving" the Irish border issue. The currency rallied nearly 2% on Thursday after a Times report of an agreement on UK bank access, even though officials on both sides denied it.
Last week’s price action was "a taste of what we could have if there was a deal on the table," said Jane Foley, head of currency strategy at Rabobank in London. "If we got a headline like the one in the Times then it’s going to be sudden," she said on Friday.
Still, the road to any deal is likely to be bumpy. Sterling will continue to be headline-driven over the next few weeks with the recent swings highlighting the "volatility that is possible on continued political uncertainty," Foley said.
Even if a deal is struck, some investors expect it not to get through parliament, with Neuberger Berman Group money manager Steve Eisman shorting two UK banks on that prospect. If parliament does approve any agreement, sterling could appreciate to $1.40, Mizuho’s head of hedge-fund sales Neil Jones said.
The positive headlines have also led investors to bring forward expectations for a Bank of England interest-rate increase to November next year, with Morgan Stanley seeing one as soon as February if there’s an earlier agreement. The BOE’s policy statement Thursday flagged the potential for the economy to run hot by late 2019, though cautioned its forecasts are dependent on the Brexit outcome.
While political pundits debate what kind of relationship Britain will have with the EU, strategists say it doesn’t matter for the UK currency. The pound could rally more than 5% to 83 pence per euro on any divorce deal, according to Nordea Bank AB analyst Andreas Steno Larsen.
"If we get a deal, almost no matter the content, the pound is cheap," said Larsen.
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