Sterling on course for best day since 1998

By Patrick Graham and Jemima Kelly

LONDON (Reuters) - Sterling saw its biggest gains since 1998 on Tuesday as Prime Minister Theresa May promised a parliamentary vote on Britain's deal to leave the EU and sought to draw a line under discussion of a "hard" or "soft" Brexit.

The pound, already up more than 1 percent as May began a keenly-awaited speech that had been extensively leaked to media, surged 2.5 percent on the day to a 10-day high of $1.2390 in the hour that followed.

It also gained almost 2 percent to 86.38 pence against the euro, with dealers reporting a widespread squeeze on short positions - or bets against sterling - taken in derivatives markets in the past few days.

One media report at the weekend had quoted a Downing Street source as predicting May's speech would trigger a significant correction in the pound. Until Tuesday's action most had assumed that would be downward, not upward.

"In laying out the government's 12 guiding principles for the upcoming negotiations, Mrs May did remove some key question marks about the government's approach and promised that both houses of parliament would get to vote," said JPMorgan Asset Management strategist Stephanie Flanders.

"This seems to have reassured investors."

The FTSE 100 share index, which has tended to rise as sterling dropped in a series of sell-offs since the vote for Brexit last June, extended an early fall, led by exporters and mining companies, as May spoke.

It last traded down 1.2 percent and was on track for its biggest daily fall since mid-November.

May said she wanted to avoid a "disruptive cliff edge" for businesses when Britain leaves the European Union and backed a phasing-in of changes in immigration, customs and regulation in areas such as financial services.

SHORT SQUEEZE

Analysts and traders said they expected more meat once the talks get under way after Britain triggers the EU's Article 50 exit process in March.

"The one revelation that stood out was the intention to put any deal before parliament, which in theory should tip the balance slightly further away from a hard Brexit," said Craig Erlam, a strategist with Oanda in London.

"This triggered a rally in the pound, which in turn was the catalyst for the short squeeze that followed."

Gilt yields, which have been falling as expectations for future UK growth suffered from concerns over the EU exit talks, rose around 2 basis points to 1.29 percent for 10-year paper.

Overnight implied volatility - a measure of expected swings in the pound expressed through currency options - halved from six-month highs hit on Monday to 13.788 percent. One-week volatility fell from 15.5 percent to around 11.4 percent.

"There was a lot of bad news in the market - people were positioned all one way, so there was always a risk (of a squeeze on those positions)," said Ian Gunner, a portfolio manager with Altana in London.

"Some people will say 'this is a hard Brexit, however she wants to dress it up', and there will be criticisms from various politicians. But it's a clean Brexit, and that's the most important thing."

(Additional reporting by Marc Jones, Vikram Subhedar, Atul Prakash and Danilo Masoni; editing by Gareth Jones)