* Pound has gained 4% vs dollar in eight days
* Investors cut short positions, spurring the rally
* Graphic: World FX rates in 2019 http://tmsnrt.rs/2egbfVh
* Graphic: Trade-weighted sterling since Brexit vote http://tmsnrt.rs/2hwV9Hv(Updates with latest prices)
By Tommy Wilkes and Olga Cotaga
LONDON, Sept 13 (Reuters) - The pound extended the lastweek's dramatic rally on Friday as investors pounced on a mediareport that Northern Ireland's largest political party hadagreed to accept some European Union rules after Brexit.
The report in the Times newspaper was swiftly denied by theparty but still supported the view that Britain and the EU canagree a deal to replace the Irish backstop, the main stickingpoint in negotiations between London and Brussels.
Talk of an alternative to the Irish backstop, which PrimeMinister Boris Johnson wants scrapped, comes as investors slashtheir short positions on the pound because of the receding risksof a no-deal Brexit.
"All those Boris shorts are beginning to bail as theyrealise he can't deliver no-deal (Brexit)," said Viraj Patel, FX& global macro strategist at Arkera.
Having hit a three-year low below $1.20 last week, sterlinghas soared since the British parliament voted to stop Johnson'sgovernment from taking Britain out of the European Union on Oct.31.
The British currency has now rallied 4% in just eight days,a significant reversal of fortunes from earlier this month whentalk of a no-deal Brexit intensified.
On Friday, the pound strengthened more than 1% to as high as$1.2475, its strongest since July 25, before settlingat $1.2431 towards the end of the London trading session.
Against the euro, sterling added as much as 0.8% to trade at88.910 pence, close to its highest since June.
Credit Suisse on Friday became the first major bank tochange its view on UK equities, pointing to the reduced chancesof the country crashing out of the EU and saying that someequities look cheap compared with foreign counterparts.
While the prospect of a no-deal Brexit on Oct. 31 has fallensharply, Britain still faces months of uncertainty and theoutcome is not clear.
Irish Prime Minister Leo Varadkar on Friday said the gapbetween Britain and the EU over Brexit remained "very wide".
ELECTION BASE CASE
Johnson wants to call a general election but lawmakers haveblocked his attempt to do so, saying they want to be sure hecannot push through a no-deal Brexit in the meantime.
Three-month implied volatility for sterling - agauge of expected price swings in the pound - remains elevatedand higher than for other maturities, signalling investorexpectations for heightened volatility in early to mid-December.
"Our base case scenario is that we are still heading for anearly election in late November or early December, and we need ashort extension (to the departure date for leaving the EU) tobreak the deadlock in parliament," Lee Hardman, a strategist atMUFG, said.
Hardman said there was some sense in the market that thegovernment was ready to push for an all-Ireland backstop which,while angering the Northern Irish party that supports thegovernment in the British parliament, could win over Brexiteersin Johnson's party.
Pushing through such a deal might require the ConservativeParty to win an outright majority in any general election, a farfrom certain scenario, Hardman added.
Opposition parties have vowed to block a no-deal Brexit butare divided about how to deliver Britain's exit from the EU.
"We'd be careful about chasing it (the pound) much higher,"Hardman said. "This is a short window of calm."
(Editing by Jan Harvey and Alex Richardson)