* Graphic: sterling and gilt yields bit.ly/2dgAXn1
* Graphic: sterling year-to-date tmsnrt.rs/2egbfVh (Updates prices, edits)
By Patrick Graham
LONDON, Oct 18 (Reuters) - Sterling jumped the most in three months in a rollercoaster session on Tuesday, as suggestions that parliament will have to ratify a British deal to leave the European Union outweighed concerns about a larger-than-expected rise in inflation.
Lawyer James Eadie, representing the government in a High Court challenge over who has the right to trigger divorce talks, helped send the pound above $1.23 for the first time in a week by saying parliament would “very likely” have to ratify any Brexit agreement.
The currency also gained more than 1 percent against the euro and on the Bank of England’s trade-weighted index, putting aside concerns that the rise in inflation signalled more headwinds for an economy facing two years of extreme political uncertainty.
The gains drove buying of UK government bonds, pushing yields down 4 basis points after a week which has seen them surge as a general rise in global yields is exacerbated by investors taking fright at Brexit risks.
“The price action this morning highlights the sensitivity of the pound to headline news on Brexit,” said Kamal Sharma, G10 strategist for Bank of America Merrill Lynch in London.
“It shows that political uncertainty is a more significant driver for the pound than the data. The market is short pounds and is coming off a string of hardline comments from the government -- this (Eadie’s comments) has provided some relief.”
Concern Britain is heading for a “hard Brexit” in which it loses access to the single market in order to impose controls on immigration have knocked 7 percent off the pound in the past three weeks. It has fallen by a fifth in value since the Brexit vote in June.
Investors generally assume British lawmakers as a whole are less in favour of a hard line on Brexit than Prime Minister Theresa May and the ministers she has put in charge of negotiations.
Data on Tuesday showed the first signs of the pound’s fall feeding through more aggressively into higher prices of consumer goods, driving the biggest rise in inflation in two years, even though headline annual price growth remains at only 1 percent.
Any rises in price pressures in the low inflation environment that has become the norm in modern developed economies have tended to support currencies because they represent rising demand pressures that should lead to policymakers raising domestic interest rates.
But members of the Bank of England’s monetary policy committee have said they will look through any short-term impact on inflation to allow a weaker pound to cushion exporters and the economy in general from Brexit-related uncertainty.
That leaves many analysts concerned that sharply higher prices of staple goods like fuel, food and other imported goods may cool domestic demand.
“We think higher inflation is negative news for the pound --the opposite to the typical impact of positive inflation surprises on G10 currencies recently,” RBC analyst Adam Cole said in a morning note.
“With the BoE likely to look through a transitory acceleration in inflation, the main effect will be to squeeze households’ real income as prices rise more quickly than wages, crimping consumer spending.”
By 1600 GMT, sterling was up 1 percent on the day at $1.2307. With the dollar broadly weaker, it hit an 11-day high of 74.7 against the trade-weighted basket of currencies used by the BoE to measures the British currency’s broader strength. It was 1.1 percent higher at 89.32 pence per euro.
Ten-year gilt yields dropped more than 4 basis points to a low of 1.077 percent.
In a study of Britain’s current account deficit -- seen as a key economic risk -- under differing Brexit scenarios, Goldman Sachs analysts said they expected more falls in sterling.
“Our main result is that -- even with the large declines that have already occurred -- the trade-weighted pound is still around 10 percent overvalued if a smaller current account deficit is the norm going forward,” Goldman Sachs analysts said in a note to clients.
“In short, sterling is not yet cheap.”
Editing by Catherine Evans and John Stonestreet