Sterling plunges vs euro as Brexit fears take centre-stage

By Saikat Chatterjee

LONDON (Reuters) - The British pound was set on Monday for its biggest daily drop against the euro in more than three months as concerns grew about the progress of Brexit negotiations.

Sentiment was also further sapped by manufacturing data that underscored the weak state of the British economy.

Traders bought sterling last week after the European Union's chief Brexit negotiator, Michel Barnier appeared to strike a conciliatory note. That raised hopes a Brexit breakthrough was imminent as Britain and the EU try to agree what a post-Brexit trade deal would look like.

But developments on the British political front dashed those expectations after Prime Minister Theresa May's former foreign secretary Boris Johnson said her Brexit strategy meant disaster for Britain.

The prospect that May's government could fail to reach an agreement that would gain parliamentary approval at home, and that Britain could potentially crash out of the EU in March with no deal in place, has worried financial markets.

"Markets clearly misunderstood Barnier's comments last week and even in the light of today's moves, investors are still underpricing the risk of a hard Brexit," said Ulrich Leuchtmann, a currency strategist at Commerzbank in Frankfurt.

Against the dollar <GBP=D3>, the British currency sank 0.8 percent to $1.2855 while there were bigger losses against the euro <EURGBP=D3> with sterling on track to post its biggest daily drop in more than three months.

The pound recovered partially in late London afternoon trading, with U.S. markets closed for a holiday.

The EU's Barnier told a German newspaper on Sunday that he strongly opposed Britain's latest proposal.

The British currency was the weakest among the major currencies with U.S. markets shut for a holiday, and it is set to fall for a third consecutive day.

Derivative markets were flashing amber with implied gauges of market volatility jumping to a six-month high <GBP1MO=> as investors grow wary about the prospects of a deal.

"With Brexit negotiations between the UK and the EU in full swing, the potential 'cliff' of a hard-Brexit has come more clearly into focus," UBS strategists said in a note.

Latest data indicates investors have ramped up their short positions on the British currency, with overall net short bets reaching their highest level since early May 2017.

Economic data provided no relief. British manufacturers had their weakest month in over two years and export orders suffered a rare decline in August, a survey showed.

"Weak economic data and bearish political background means this is a double-pronged attack on sterling," said Neil Jones, Mizuho Bank's head of hedge fund sales based in London.

GRAPHICS - GBP Positions: http://reut.rs/1KbTvEA

Graphic: Trade-weighted sterling since Brexit vote http://tmsnrt.rs/2hwV9Hv

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

(Reporting by Saikat Chatterjee; editing by Alexander Smith)