October 5, 2018 / 8:53 AM / in 6 months

UPDATE 2-Sterling rallies as EU negotiators see Brexit divorce deal "very close"

* Graphic: World FX rates in 2018 tmsnrt.rs/2egbfVh

* Graphic: Trade-weighted sterling since Brexit vote tmsnrt.rs/2hwV9Hv (Adds quotes, updates prices)

LONDON, Oct 5 (Reuters) - Sterling touched a two-month high versus the euro and gained against the dollar on Friday after the European Union’s Brexit negotiators said they believed a divorce deal with Britain was “very close”.

The pound rose 0.3 percent to 88.045 pence, its highest since July 4, on the Reuters report, which cited two diplomatic sources who attended a meeting with a member of EU Brexit negotiator Michel Barnier’s team.

The British currency also rose to a five-day high versus the dollar, hitting as high as $1.3101 before giving up some of those gains.

“Continued concerns over the Italian budget deficit and sovereign rating contrasts with what seems to be an improving Brexit outlook,” Morgan Stanley analysts said in a note, pointing to possible further downside momentum towards 87 pence per euro.

After a summer sell-off fuelled by a spike in worries Britain would exit the EU disruptively without a trade deal in place, sterling has recovered as optimism grows that Brussels and London can overcome differences and reach an agreement.

Crucial to any deal is resolving what to do about checks on the border that will separate Northern Ireland, part of the United Kingdom, and EU member state Ireland.

EU sources said on Thursday that negotiators saw the outline of a compromise on the Irish border issue, raising hopes that a new British offer could unlock a deal with less than 180 days before Britain leaves the trading bloc.

Many investors are not pricing for a deal to be announced at an EU summit later this month, but for November.

Any delay beyond then is likely to hit the pound hard - most traders are reluctant to push sterling much higher until the prospect of a deal, which would then need to be passed in the British parliament, becomes much clearer.

“I’ve been banging the long GBP drum for over a month now and already we’re nearly 3 percent in the money. That’s the sort of move in a currency that makes it difficult to enter into fresh longs for most FX folks who fear the pullback that can happen on the simplest of negative Michel Barnier headlines,” Nomura strategist Jordan Rochester wrote in a client note.

But he said many investors were sitting on the sidelines, preferring not to listen to every headline.

“In the fullness of time we’ll look back at this as the early signs that a deal will be done, a transition deal secured and whatever Brexit the UK aims for (hard or soft), we’ll have another two years (or more) to adjust to it,” he said. (Reporting by Tommy Wilkes and Tom Finn Editing by Karin Strohecker and Mark Heinrich)

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