Sterling has surged the most in six months on speculation that successful Brexit trade negotiations this week could help shield Britain from a messy rupture with the EU.
The UK currency outperformed major currencies to rise as much as 1.4% to $1.2930, as the markets digested a more conciliatory tone from officials on both sides.
Some investors are betting that despite some lingering tensions, the UK isn’t in a position to pursue political brinkmanship for much further.
“Given that we are in the middle of the Covid crisis, I think it is well understood that the UK cannot make good on a threat to end up with no deal,” said Mark Dowding, chief investment officer at BlueBay Asset Management.
“Our sense was that the UK government would always try and create an impression of crisis, so that when they agree a deal (albeit a very skinny one) they can herald this as a triumph,” he said.
Britain risks crashing out of the EU’s single market without a trade accord at year-end if a deal isn’t reached.
The EU’s chief Brexit negotiator Michel Barnier and his British counterpart, David Frost, will hold a final round of scheduled discussions starting Tuesday.
If they make enough progress by Friday, they could embark on a two-week period of intense discussions -- the so-called Brussels “tunnel” -- to hammer out an accord in time for a summit of EU leaders on October 15.
Mr Dowding predicts an agreement “in principle” within two weeks.
He switched to a long position on the pound and expects sterling to rally about 3% to 88 pence against the euro by mid-October.
The pound is being buoyed by hopes on both sides that a deal is in sight, said Jane Foley, head of foreign-exchange strategy at Rabobank in London.
An agreement could push the pound up by nearly 2% to 89 pence per euro in October, she said.
The outlook for the currency has also improved after the EU enabled banks to keep using London’s clearing houses next year, helping to avoid a cliff-edge scenario for financial services.
However, “even if there is a deal there are likely to be several gaps and this could cut short any relief rally,” Ms Foley said, adding that failure to reach agreement could drag the pound down to 92 pence against the euro.
Even if tensions are thawing they have some way to go.
The EU renewed its threat to take legal action against the UK over its plan to breach the Brexit divorce deal, saying the move was a serious violation of international law.
Yet the final scheduled round of Brexit talks appear to be fueling optimism among hedge funds, according to a Europe-based trader.
This is reflected by one-month bearish bets retreating from the highs they saw in mid-September.