* Graphic: World FX rates in 2018 tmsnrt.rs/2egbfVh
* Sterling hovers just off multi-month high vs dlr, euro
* (Releads, updates throughout, adds quotes)
By Sujata Rao
LONDON, Jan 14 (Reuters) - Sterling briefly surged to two-month highs against the dollar on Monday after a report, subsequently denied, that a pro-Brexit faction of lawmakers could support Prime Minister Theresa May’s Brexit divorce deal in parliament.
The currency had firmed earlier in the day as markets seized on another warning from May that lawmakers’ failure to approve her Brexit deal in Tuesday’s parliament vote could lead to the UK staying in the European Union.
While May urged parliament to give her deal “a second look”, the proposal looks almost certain to get the thumbs down. A pro-Brexit Conservative faction, the European Research Group, denied ITV Political Editor Robert Peston’s source-based report that it could support May’s deal.
“What it tells you is that the situation is very fluid but also that parliament is definitely asserting its power on the policy process,” Societe Generale strategist Alvin Tan said.
“Chances of a no-deal Brexit have fallen but there remains great uncertainty about the terminal point of this.”
The denial by ERG member Steve Baker knocked sterling off two-month highs of $1.2930 though it stayed 0.3 percent up on the day at $1.2876 by 1700 GMT.
Against the euro it briefly rose to 88.755 pence, up 0.6 percent on the day, the highest since Dec. 5 but then fell back to 89.2 pence.
Sterling last week posted its fourth week in the black, rising sharply on Friday on suggestions that Britain could seek to delay its scheduled March 29 date to exit the European Union. But it has also benefited from recent dollar weakness and last week from a fall in the euro.
However, the outlook remains uncertain - a last-minute Brexit deal, a disorderly or no-deal exit, a new referendum or remaining in the bloc are all seen as possible.
But analysts noted growing signs parliament was prepared to exercise its clout to prevent a no-deal or “hard” Brexit.
May also said in a speech earlier on Monday that blocking Brexit was now more likely than Britain leaving the European Union without a deal. While she was invoking a line she has deployed in the past to persuade Conservative party lawmakers to back her deal, it reinforced markets’ hopes that Brexit could be softened or even reversed.
“Theresa May seems to think there is a bigger chance of no-Brexit than of no-deal Brexit. Anything that seems to reduce the chances of a ‘hard’ Brexit is something that would provide solace to investors,” said Jane Foley, FX strategist at Rabobank.
Many have also started to price the possibility of another referendum being called which could result in the UK remaining in the EU, a so-called people’s vote.
That has diminished expectations for sterling swings in recent weeks but the vol as it is known rose back on Monday to a one-week high.
However, the risk that sterling will fall against the dollar remains near the lowest level in more than four months, according to one-month risk reversals, a gauge of market positioning.
“There is growing upside risk to sterling given that the chances of a no-deal scenario has fallen,” Tan said. (Reporting by Tom Finn and Sujata Rao; additional reporting by Dhara Ranasinghe Editing by Robin Pomeroy)