By Olga Cotaga
LONDON (Reuters) - Sterling clawed back some ground on Monday, benefiting from political ructions in Italy that hit the euro, but concerns over Brexit kept the UK currency within sight of multi-year lows.
The pound was up by 0.5% against the euro at 92.59 pence, after Deputy Prime Minister Matteo Salvini threatened to bring down Italy's coalition government. Euro weakness also helped sterling rise by the same percentage against the dollar, to $1.2083, for its biggest daily move in three weeks.
The euro hit a one-week low of $1.1162 and a 28-month low of 117.52 against the Japanese yen.
An unexpected second-quarter contraction in Britain's economy had late last week sharpened the market focus on fears that the country will crash out of the European Union at the end of October without a transitional deal.
Late on Sunday, sterling plunged to 93.26 pence against the euro, the lowest since October 2009 apart from a flash crash in October 2016, and to a 31-month low of $1.2015 versus the dollar.
GRAPHIC: Euro-sterling - https://tmsnrt.rs/2YGvrqs
GRAPHIC: Sterling plunge towards $1.20 - https://tmsnrt.rs/2MVL85W
"A significant compression of UK (debt) yields and Brexit undertones" are why sterling dropped against the euro, said Kamal Sharma, forex strategist at Bank of America Merrill Lynch. This is a "natural breeding ground for sterling losses," he said.
Low liquidity and media reports that Ireland will not renegotiate the Brexit backstop at an expected meeting with British Prime Minister Boris Johnson this month also weakened sterling, analysts said.
The backstop, part of the withdrawal agreement that former Prime Minister Theresa May struck with Brussels in November but British lawmakers failed to ratify, is a major sticking point in efforts to agree an orderly exit.
With the Brexit deadline approaching, leveraged funds increased their net short positions on sterling in the week to Aug. 6 to a total of $7.83 billion, the highest since April 2017, according to CFTC data.
GRAPHIC: Sterling net short positioning highest since April 2017 - https://tmsnrt.rs/2YFzJhD
Three-month risk reversals, which encapsulate the Oct. 31 Brexit deadline, paint a similar picture.
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As currency traders offloaded the pound, some fixed income investors viewed opportunities to buy UK government bonds.
Gilts would rally if the Bank of England were to cut interest rates in case of a disorderly British exit from the EU, said Mohammed Kazmi, portfolio manager of the UBAM Absolute Return Low Vol Fixed Income Fund at Union Bancaire Privée.
Money markets are pricing in a 25 basis-point interest rate cut by the BoE by January.
ADVERTISEMENT"It does make Gilts more attractive," Kazmi said, especially in an environment of negative yields across continental Europe. "We’ve been holding more duration across our funds and we think of shifting that (view) into the UK," he said.
(Reporting by Olga Cotaga; editing by John Stonestreet)
