UPDATE 1-Sterling strengthens after EU Brexit divorce deal "very close" report

Sterling touched a two-month high versus the euro and gained against the dollar on Friday after the European Union's Brexit negotiators said they believed a divorce deal with Britain was "very close".

The pound rose 0.3 per cent to 88.14 pence, its highest since July 9, on the Reuters report, which cited two sources.

The British currency also rose to a five-day high versus the dollar of $1.3060 before giving up most of those gains.

"Continued concerns over the Italian budget deficit and sovereign rating contrasts with what seems to be an improving Brexit outlook," Morgan Stanley analysts said in a note, pointing to possible further downside momentum towards 87 pence per euro.

After a summer sell-off fuelled by a spike in worries Britain would exit the EU without a trade deal in place, sterling has recovered in recent weeks as optimism grows that Brussels and London can overcome differences and reach an agreement.

Crucial to any deal is resolving what to do about checks on a border that will separate Northern Ireland, part of the United Kingdom, and EU-member state Ireland.

EU sources said on Thursday that negotiators saw the outline of a compromise on the Irish border issue, raising hopes that a new British offer could unlock a deal with less than 180 days before Britain leaves the trading block.

Many investors are not pricing for a deal to be announced at an EU summit later this month, but for November.

Any delay beyond then is likely to hit the pound hard - most traders are reluctant to push sterling much higher until the prospect of a deal, which would then need to be passed in the British parliament, becomes much clearer. (Reporting by Tommy Wilkes and Tom Finn Editing by Karin Strohecker and Janet Lawrence)

(With inputs from agencies.)