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Sterling jumps to 10-day high on report of possible Brexit transition offer

* Graphic: sterling and gilt yields http://bit.ly/2dgAXn1

* Graphic: World FX rates in 2017 http://tmsnrt.rs/2egbfVh

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

LONDON, Oct 13 (Reuters) - Sterling rose on Friday to a 10-day high, boosted by a report in Germany's Handelsblatt newspaper that the European Union could offer Britain a two-year transitional Brexit deal.

The pound had tumbled as low as $1.3122 on Thursday after the EU's chief Brexit negotiator Michel Barnier told reporters that talks around Britain's divorce payment had hit an "impasse."

Last week, the British currency suffered its worst week in a year against the dollar, after a more than 2 percent fall.

But after the Handelsblatt report the pound rose to 1.3301 by Friday morning, up 0.3 percent on the day, its highest level since October 3rd.

Handelsblatt reported on Thurday evening that Barnier wanted to offer Britain the chance to stay in the EU's single market and customs union for a two-year transition if London agreed to settle its financial obligations with the bloc and sign a divorce agreement.

The German newspaper, citing EU diplomats, said Britain would also have to meet all the obligations of EU membership during the transition and Barnier was expected to make the proposal during a meeting of EU ambassadors on Friday.

"The pound's whipsaw price action yesterday is indicative of the currencys somewhat inexplicable sensitivity to Brexit-related headlines," said Viraj Patel, an FX strategist at ING.

Patel said markets had priced in a higher probability of a no deal Brexit as the fifth round of talks concluded, but that investors had reassessed these fears after the newspaper report.

However, the outlook remains fragile, with some market watchers warning against the rallies.

"The price action in GBP should act as a warning to investors: the current GBP levels are based on the hope that everything will be ok in the end," wrote analysts for Commerzbank in a note. "However, until this reliably emerges there is a considerable risk of the GBP collapsing."

Prime Minister Theresa May's government has said Britain will cease to be a member of the single market after its scheduled departure from the EU in March 2019 as it would not agree to continue to allow automatic free movement of EU workers into the country.

Against the euro, sterling dropped to 88.33 pence , its lowest since October 5th.

(Reporting by Fanny Potkin; Editing by Gareth Jones)