Rising hopes for a breakthrough in Brexit trade talks have pushed sterling to its strongest level since May 2018 against the struggling dollar.

The pound muscled as much as 0.65 per cent higher on Wednesday to trade at $1.3548, breaking through the previous 2020 peak it hit in early December. The euro also weakened around 0.3 per cent against sterling to 90 pence.

The bounce in sterling follows its worst week against the dollar since September, in a continuation of a volatile year. The gains have been massaged by a weak dollar ahead of a Federal Reserve policy decision scheduled for Wednesday afternoon in Washington. Upbeat data on the eurozone economy, coupled with hopes for fresh US fiscal stimulus, have also placed broad pressure on the haven greenback.

Renewed hopes for a deal come after the UK government put its parliamentary members on standby to vote on a potential agreement. Negotiations between the two sides have to conclude before the last day of the year for the UK to have an agreement on its trading terms with its European peer before the Brexit transition period ends.

Analysts expect the pound to power higher against both the dollar and the euro if negotiations are successful.

“Markets should react positively to the news that a deal has been reached. The cleaning up of this endless saga will provide relief to Brexit-weary investors and the public alike,” said Seema Shah, chief strategist at Principal Global Investors.

Derek Halpenny, head of research at MUFG Bank, said the pound would likely trade around $1.38 immediately after the news of a deal, but the currency’s further path will be dependent on the details of the agreement.

Line chart of  showing Sterling hits new 2020 high

Beyond the immediate bounce, sterling is expected to face headwinds in 2021 as the economy adjusts to the new relationship. Due to the late stage in talks, investors expect a degree of uncertainty to persist in 2021, reining in the pound’s gains.

“We are optimistic that the UK will not crash out of the EU without a deal, though we expect any deal to be a fudge deal with scope for negotiations to carry on in 2021,” said analysts at Jefferies.

Mr Halpenny said the market’s reaction to a deal will depend on whether the EU agrees to reciprocate on the UK’s decision to suspend custom checks for a short period of time.

“Without a customs checks suspension, gridlock and disruptions would be immediate in January and that would mean negative sentiment would emerge very quickly limiting sterling’s gains,” said Mr Halpenny.

The response from the UK central bank to the consequences of the talks will also shape sterling’s path, analysts said. Policymakers at the Bank of England are set to decide on rates for the last time this year on Thursday, but in the absence of a trade agreement, investor focus remains firmly on Brexit, according to Bank of America analysts.

The BoE is expected to keep its key rate unchanged and to keep its powder dry until there is clarity around Brexit. Robert Wood, a UK economist at BofA, said the central bank would likely cut interest rates to negative territory if a trade deal falls through, but only in February.

“Brexit news remains the potential near-term catalyst for a change at the BoE. If markets become jittery, the BoE could increase the QE purchase pace at short notice,” Mr Wood said.