Image © European Union

- Pound extends rebound from multi-month lows

- Merkel says backstop can be overwritten

- Comments add to signs of growing EU shift

German Chancellor Angela Merkel is the latest senior EU leader to suggest there was room for manoeuvre on the Irish backstop question, a day following similar comments from Irish leader Leo Varadkar and Chief Brexit negotiator Michel Barnier.

Indications that there will be room for the incoming UK Prime Minister to negotiate on the matter has offered a bid to Pound Sterling which has been under notable pressure over recent weeks.

The Pound-to-Euro exchange rate was seen trading at 1.1145, having been as low as 1.1047 earlier in the week following Merkel's comments.

The Pound-to-Dollar exchange rate was seen trading at 1.2533, having been as low as 1.2382 earlier in the week.

Merkel said if negotiators are able to find a solution to the Irish backstop question the political declaration, then it could override the backstop.

"The Withdrawal Agreement is the Withdrawal Agreement," Merkel told a news conference, adding:

"But the moment that a solution for the management of the border is found in (the declaration on) the future relationship - so for the European Union's future ties to Britain - which basically squares the circle - on the one hand I have no physical border but on the other hand the EU Single Market ends - that satisfies both questions, then the backstop will be overwritten so-to-speak."

The current Brexit deal is made up of a Withdrawal Agreement and a political declaration. The WA is a legally-binding international treaty and it says that should any trade deal fail to keep the Northern Irish border open, then the UK must abide by EU rules on trade until such a time that a solution is found.

The political declaration is an attachment to the WA, and provides commitments for the future relationship. It is more flexible and can be subject to multiple changes, and the EU have often preferred to offer the majority of their concessions within this text.

However, for Brexiteers, it is the WA that counts as this is the legally-binding treaty.

How Merkel's idea can neuter the backstop without actually reopening the WA remains to be seen.

"We understand that a change in the Withdrawal Agreement now essentially only requires Ireland's approval. Assuming an A50 extension, we think a new EU Commission will facilitate the climb-down. Importantly, we note incoming Commission President von der Leyen strongly opposes No Deal, and could be a key player to help facilitate this process. A “time-line” instead of a “time-limit” might be one solution, but these expectations remain highly fluid," says Ned Rumpeltin, European Head of FX Strategy at TD Securities in London.

What is important, from a foreign exchange perspective, is that there are without doubts signs of movement from the EU.

No doubt, a more hardline and uncompromising tone set by the Boris Johnson - the favourite to replace Prime Minister Theresa May next week - will be resonating through EU capitals.

For Sterling, any negotiated Brexit would quash layers of chronic political uncertainty and help spark a potentially sustainable recovery.

Merkel's comments follow those of Michel Barnier made Thursday that he is ready to work on alternative arrangements for the Irish border.

"Barnier says open to Alternative Irish Border plan. Sequence of events post Tory PM being elected on 22 July points to renewed UK-EU talks and optimism for a Brexit deal. Oversold GBPUSD has asymmetric headline risks (more sensitive to positive over negative). Bullish hopes," says Viraj Patel, a foreign exchange strategist with Arkera.

A spike was detected in GBP/USD and other Sterling pairs when Barnier's Irish border comments hit the newswires.

Barnier's comments were soon followed up by comments from Ireland's Prime Minister Leo Varadkar.

Varadkar has said there are a few ways to avoid a hard border and if there are proposals that genuinely finds a solution, he will listen to them.

However, if there are no meaningful suggestions, "we cannot move away from backstop," Varadkar told broadcaster RTE.

He adds that if there is a no-deal Brexit outcome, it will be the choice of the UK government.

The tone from Varadkar and Barnier - two central figures from the EU side - suggest there is some willingness for movement on the key issue of the backstop.

Therefore, the prospect of a negotiated settlement remains alive and there is a risk that markets feel they have oversold the Pound as a result.

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