October 22, 2018 / 9:47 AM / 23 days ago

UPDATE 4-Sterling falls to 2-1/2 week low on fear of challenge to PM May

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

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

By Sujata Rao

LONDON, Oct 22 (Reuters) - Sterling fell on Monday as fears grew that the Irish border issue and disagreements within Britain’s ruling Conservatives over Brexit could see Prime Minister Theresa May face a serious leadership challenge.

The pound lost ground against the dollar and the euro, at one point falling close to 1 percent to the greenback, though it later clawed back some of the losses.

Sunday newspapers quoting unnamed lawmakers as saying May should prepare for a challenge to her leadership.

A report by the Telegraph newspaper’s deputy political editor said the DUP, the Northern Irish party which props up May’s government, would back an amendment proposed by rebel Brexiteer lawmakers that would effectively make the European Union’s proposal on the Irish border illegal

However, a rebel lawmaker, Steve Baker who had tabled the amendments, was later reported as planning to withdraw the proposal, according to The Times newspaper

Lee Hardman, FX strategist at MUFG in London said he still expected a deal eventually to be struck over Brexit but added: “The path to a deal seems to have become a bit harder.”

“On the weekend, we saw increasing concern over political instability in the UK and the threat of another leadership challenge back on the table,” Hardman said.

By 1530 GMT, sterling was down 0.65 percent, having earlier hit a low of $1.2957, its weakest since Oct. 4.

Against the euro, the pound was down 0.3 percent , well off earlier lows of 88.57 pence which had been a 2 1/2-week low. Technicals indicated sterling had fallen below its 55-day moving average — closing below this level would signal more downside risks, chartists said.

Jittery markets closely watched May’s speech to parliament, at which she is expected to say that 95 percent of the Brexit divorce deal has been settled. But she will maintain opposition to the European Union’s proposal for the land border with Northern Ireland.

However, her proposal to extend a status-quo transition period beyond the current proposed date of December 2021 has angered the eurosceptics in her party.

“(The leadership challenge issue) is hanging over sterling, which is (also) waiting for another steer on Brexit, likely from this address from May today,” Investec economist Victoria Clarke said.

Late last week, Brexit optimism, along with a paring of dollar long positions, saw short sterling bets fall to a net 50,353 contracts, versus more than 60,000 the week before, calculations by Reuters and the Commodity Futures Trading Commission showed.

But analysts at Nomura said they were taking profit on long sterling positions, noting short-term risks.

“Despite our view that a leadership confidence vote on May is no more than hyped-up tail risk, we admit the Conservative Party has never looked closer to triggering such action as it does today,” Nomura said, noting that centrist Tories as well as Brexiteers were disgruntled with the direction of Brexit policy.

Additional reporting by Tommy Wilkes; Editing by Robin Pomeroy

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