LONDON (Reuters) - The British pound tumbled two cents against the dollar on Friday and headed for its biggest daily drop this year after Prime Minister Theresa May said Brexit talks with the European Union had reached an impasse and called for new proposals.

FILE PHOTO: Wads of British Pound Sterling banknotes are stacked in piles at the Money Service Austria company's headquarters in Vienna, Austria, November 16, 2017. REUTERS/Leonhard Foeger

She said EU leaders must table new alternatives to her Brexit proposals if both sides were to break the deadlock in their negotiations.

Coming at the end of a week when the pound rallied to a two-month high on hopes of an imminent Brexit deal, Friday’s selloff was a brutal reminder for investors of the currency’s vulnerability to Brexit headlines.

The deterioration in negotiations - accelerated by warnings from EU leaders on Thursday that May must give ground on trade and the Irish border issue by November to clinch an agreement - means the pound has wiped out its entire gains of the week.

“Either there is compromise or a no-deal but the risks of no-deal have risen,” said Sarah Hewin, Chief Economist, Europe, at Standard Chartered. “The market is still taking a view that the most likely outcome is a deal. At the moment (sterling) seems to be moving one day at a time, one hour at a time and one headline at a time but the fundamental issue is still the same.”

The pound fell to as low as $1.3053 GBP=D3 and was more than two cents below where it began the day.

One month implied volatility - a measure of expected price swings - jumped to its highest since February, in its biggest daily rise since January.

(GRAPHIC: 1-month implied volatility on sterling registers biggest daily rise since Jan 2018 - reut.rs/2MQdXgx)

Against the euro, sterling slid 1.3 percent to 89.95 pence EURGBP=D3 while yields on 10-year British government bonds slipped to 1.55 percent, down 3.4 basis points on the day GB10YT=RR.

Nomura analysts said “fast money”, usually meaning hedge funds and day traders, had been building long positions in sterling in recent days and after May’s speech “will be reflecting on the next steps from here”.

“The question investors need to ask themselves is do they have the foresight to hold GBP longs at the historically cheap levels but wear the ins and outs of the day to day noise of politics,” they wrote in a note to clients.

IRISH PROBLEM

Crashing out of the EU without any deal would damage Britain’s economy, hurt its international trade competitiveness and frighten investors, economists warn.

The two sides remain divided over how to ensure the border between Northern Ireland, part of the UK, and EU member Ireland remains free of frontier controls after Brexit.

Many currency market analysts remain confident that the two sides will reach agreement, as both Brussels and London have much to lose if Britain crashes out the bloc without an arrangement for trade on March 29, 2019.

“Just not entirely convinced that the actual odds of a no-deal have changed much in the past few weeks (despite the big moves). The pound remains a sentiment-driven currency,” Viraj Patel, an analyst at ING and sterling bull, wrote on Twitter.

Many investors, however, have rushed to hedge against more weakness in the currency should the negotiations with the EU collapse.

Better-than-expected retail sales and higher inflation numbers published earlier this week had boosted the pound before Friday’s Brexit headlines.