UPDATE 1-Pound bounces on hint UK parliament must back EU exit – Reuters

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

* Graphic: sterling year-to-date tmsnrt.rs/2egbfVh (New throughout after headlines from UK lawyer in Brexit case)

By Patrick Graham

LONDON, Oct 18 Sterling surged by as much as 1 percent in a rollercoaster session on Tuesday, buffeted by mixed interpretations of a rise in inflation and suggestions that parliament will have to ratify a British deal to leave the European Union.

Lawyer James Eadie, representing the government in a High Court challenge over who has the right to trigger divorce talks, sent the pound briefly to $1.2300 by saying parliament would “very likely” have to ratify any Brexit deal with the EU.

Sterling also gained 0.8 percent against the euro, to 89.56 pence per euro, putting aside concerns that a faster-than-expected rise in inflation signalled more headwinds for an economy facing two years of extreme political uncertainty.

The pound’s gains drove buying of UK government bonds, pushing yields down 4 basis points after a week which has seen them surge as a general rise in global yields is exacerbated by investors taking fright at Brexit risks.

“The price action this morning highlights the sensitivity of the pound to headline news on Brexit,” said Kamal Sharma, G10 strategist for Bank of America Merrill Lynch in London.

“It shows that political uncertainty is a more significant driver for the pound than the data. The market is short pounds and is coming off a string of hardline comments from the government — this (Eadie’s comments) has provided some relief.”

Concern Britain is heading for a “hard Brexit” in which it loses access to the single market in order to impose controls on immigration have knocked another 7 percent off the pound in the past three weeks. It has fallen by a fifth in value since the Brexit vote in June.

Investors generally assume British MPs as a whole are less in favour of a hard line on Brexit than Prime Minister Theresa May and the ministers she has put in charge of negotiations.

PRICE JUMP

Data on Tuesday showed the first signs of the pound’s fall feeding through more aggressively into higher prices of consumer goods, driving the biggest rise in inflation in two years, even though headline annual price growth remains at only 1 percent.

Classically, rises in inflation tend to support currencies because they represent rising demand pressures that should lead to policymakers raising domestic interest rates.

But members of the Bank of England’s monetary policy committee have stressed they will look through any short-term impact on inflation to allow a weaker pound to cushion exporters and the economy in general from Brexit-related uncertainty.

That leaves many analysts concerned that sharply higher prices of staple goods like fuel, food and other imported goods may cool domestic demand.

“We think higher inflation is negative news for the pound –the opposite to the typical impact of positive inflation surprises on G10 currencies recently,” RBC analyst Adam Cole said in a morning note.

“With the BoE likely to look through a transitory acceleration in inflation, the main effect will be to squeeze households’ real income as prices rise more quickly than wages, crimping consumer spending.”

By midday in London, sterling was trading 0.8 percent stronger on the day at $1.2279. With the dollar broadly weaker, it hit an eight-day high of 74.4 against the trade-weighted basket of currencies used by the BoE to measures the British currency’s broader strength.

Ten-year gilt yields dropped more than 4 basis points to stand at a low of 1.083 percent. Their yield spread over German Bunds tightened by 3 basis points.

In a study of Britain’s current account deficit — seen as a key economic risk — under differing Brexit scenarios, Goldman Sachs analysts said they expected more falls in sterling.

“Our main result is that — even with the large declines that have already occurred — the trade-weighted Pound is still around 10 percent overvalued if a smaller current account deficit is the norm going forward,” Goldman Sachs analysts said in a note to clients.

“In short, sterling is not yet cheap.”

(Editing by Catherine Evans)