By Saikat Chatterjee
LONDON(Reuters) - Sterling trimmed earlier gains but held near five-week highs in volatile trading on Tuesday, with sentiment boosted by overnight comments from the European Union's chief negotiator that a Brexit deal is possible within weeks.
Though economic data this week has been broadly supportive of sterling, with latest figures showing British workers' underlying pay growth picking up faster than expected, market attention is squarely focussed on Brexit headlines.
The British currency hit its highest level since early August in early trading at $1.3087, but gave up some gains after the pay data to stand 0.1 percent up on the day at $1.3041. Against the euro, the pound was flat at 89.02 pence.
With less than seven months to go before the United Kingdom is due to leave the European Union, recent comments from policymakers have been perceived by markets as conciliatory.
On Monday diplomats and officials said that EU leaders were likely to hold a special Brexit summit in mid-November in the hope of signing off on a divorce deal with Britain.
However, investors have shied from big bets, given the lack of concrete progress and a few big event risks such as the ruling Conservative's party conference at the end of September, at which Prime Minister Theresa May could face a leadership challenge.
Derivative traders at banks have said there is increased interest from hedge funds in buying short-dated currency options on the British pound, betting that swings in the pound will intensify as the pace of negotiations picks up.
Daily swings in sterling over the past week are higher than what similar gauges in the derivative markets are indicating, encouraging speculators to buy relatively cheap options betting on a pick-up in volatility.
In the cash markets, hedge funds remain negative on the British currency, according to latest positioning data, showing a net $5.5 billion outstanding short position.
Growing expectations of a Brexit deal are eroding the safe-haven appeal for government debt, with yields on ten-year British government bonds at a one-month high and German yields also rose.
"Recent comments from the UK and the European side have been remarkably positive for the British currency, but these negotiations are by no means a straightforward affair and markets should be prepared for more volatility," said Morten Helt, a currency strategist at Danske Bank.
Hopes of a deal breakthrough has helped sterling to rally nearly 2.5 percent from Wednesday's lows below $1.28 and tighten five-year credit default swaps by more than a basis point from a near 1-1/2 year high hit this month.
(Reporting by Saikat Chatterjee; Editing by David Goodman)