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UPDATE 2-Pound surges as Brexit deal optimism swells

Elizabeth Howcroft

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* Cable up nearly 2%; biggest two-day rally since June 2016

* Derivatives traders turn bullish on sterling

* Graphic: World FX rates in 2019 http://tmsnrt.rs/2egbfVh

* Graphic: Trade-weighted sterling since Brexit vote http://tmsnrt.rs/2hwV9Hv (Adds Barnier comments, option mkt details, updates prices)

LONDON, Oct 11 (Reuters) - Sterling surged on Friday to a three-month high as investors rushed to price in the prospect of a last-minute Brexit deal between the European Union and Britain.

The pound has rallied more than 3% since Thursday, its biggest two-day gain since mid-June 2016, before the British public voted to leave the EU.

EU Brexit negotiator Michel Barnier said he had had a "constructive" meeting with his British counterpart, Stephen Barclay.

That followed a meeting on Thursday between the Irish and British prime ministers, who released a joint statement saying they could see "a pathway to a possible deal", surprising many investors who believed chances of an agreement before Oct. 31 were all but dead and another extension to the deadline the most likely outcome.

The pound rose nearly 2% to a three-month high of $1.2685 in London trading.

Versus the euro, the pound strengthened as much as 1.4% to 87.20 pence.

British stocks also rallied, gilt yields rose and money markets no longer fully priced in a 25 basis point Bank of England interest rate cut before December 2020.

Derivatives traders regained confidence in the pound, with bullish bets exceeding bearish views for the first time since January 2018 on Friday, according to the currency derivatives market, suggesting further gains for sterling.

Kenneth Broux, FX strategist at Societe Generale, said there was a scramble to cover positions given the newfound optimism that a Brexit deal would be reached.

"We've seen quite a bit of volatility this morning after the meltup yesterday. The market is very thin. I think it's very important to specify that sterling liquidity is very thin so volatility is high," Broux said.

But he added that given the broadly bearish positions in sterling markets, "the obvious conclusion is that well see a squeeze higher".

"TIME IS PRACTICALLY UP"

Sounding a more cautious tone, top EU official Donald Tusk said "time is practically up" for Britain to reach a Brexit deal. That hurt the pound temporarily in a very volatile day for the currency.

One dealer in London attributed price swings to "algos" - or computer-generated trading algorithms - in a headline-driven market.

Hopes are that a meeting between British and EU negotiators will pave the way for a Brexit transition deal at an Oct. 17-18 summit.. But some are sceptical Johnson will succeed in getting the agreement past Britain's parliament

"If the meeting doesn't go too badly you may get a further pop (higher in sterling) but it will be a matter of hours for the ERG and DUP to opine on it," said Tim Graf, head of macro strategy at Slate Street Global Advisors, referring to the pro-Brexit faction of the British Conservative party and the Northern Irish party which supports the UK government.

Deutsche Bank's forex strategist George Saravelos said he was "turning more optimistic on Brexit" and no longer negative on the pound, while JPMorgan said the Anglo-Irish statement may have "changed everything".

The sterling rally undermined UK's export-heavy FTSE 100 stocks index but domestically focused UK retailers, banks and housebuilders benefited, rising 4%- 6%.

Irish stocks also rallied while Irish government bond yields fell .

(Reporting by Elizabeth Howcroft; Additional reporting by Thyagaraju Adinarayan, Ritvik Carvalho, Saikat Chatterjee, Sujata Rao Editing by Alison Williams and Kirsten Donovan)