June 10, 2017 1:25 am JST

Britain's pound sinks, lifting shares, after election shock

LONDON (Reuters) -- Britain's pound tumbled on Friday, lifting the country's main FTSE share index, after an election that denied any party a majority in parliament and fomented a sense of political chaos just days before Brexit talks begin.

Prime Minister Theresa May said she would form a government with help from Northern Irish unionists, despite having failed to win the stronger mandate she had sought to conduct exit talks with the rest of the European Union.

While sterling registered its biggest daily fall in eight months, the slump appeared to be checked by expectations from some investors that the government may pursue a softer stance on Brexit and even loosen the purse strings to assuage an austerity-weary electorate.

"Faced with this uncertainty, the immediate market response seems fairly reasonable: a modest sell-off in the pound," PIMCO's head of sterling portfolio management, Mike Amey, said.

"Looking ahead, assuming a base case of easier fiscal policy and a "softer" Brexit, we would expect...stability returning to the pound."

Others, though, have argued that without a strong Brexit mandate, the government's hand in negotiations may have been weakened.

The pound touched an eight-week low against the dollar and its lowest levels in seven months versus the euro, before recovering some ground later in the day.

London's main FTSE 100 stock index, composed of multinational companies that largely earn in foreign currency and therefore benefit when the pound falls, climbed as much as 1.3 percent, before closing up 1 percent on the day.

The more domestically focused FTSE 250 index, meanwhile, whose constituents are vulnerable to sterling weakness, recovered from an earlier loss to close slightly higher on the day.

Housebuilders suffered and gold miners climbed as investors rushed to safety and ditched stocks more exposed to domestic instability. Shares in some British utilities rose on diminishing concerns that energy prices would be capped, as planned by the Conservatives. United Utilities and SSE were both up 0.2 percent.

Challenger banks Metro , OneSavings and Virgin Money, which analysts said were most sensitive to domestic growth, fell particularly sharply. Blue-chip bank RBS also fell.

British 10-year gilt yields fell nearly 3 basis points to 1.01 percent as investors bet on political uncertainty keeping Bank of England rates on hold for longer.

"Given the degree of uncertainty that's been unleashed by this election about what will happen next with the Brexit negotiations and how stable this government will be, the prospect of the Bank of England raising rates is pretty much non-existent. People are pushing it back to perhaps 2020," said Marc Ostwald, a strategist at ADM Investor Services.

UK credit default swaps (CDS) - which reflect the cost of buying protection against a government defaulting - were trading around their highest since late April.

STERLING SKIDS

Having slid over 2.5 percent to as low as $1.2636 in early European trade, sterling had recovered to $1.2737 by 1540 GMT.

That still left sterling down 1.7 percent against the dollar on the day and on track for its biggest one-day fall since October, though that move was dwarfed by an almost 8 percent dive the day after last June's EU referendum.

The pound was almost back to where it had been trading before May called the election on April 18 gave it a boost.

The one-month sterling-dollar risk reversal, a measure of the balance of bets on the pound rising or falling in the next month, had touched its lowest level since September overnight, indicating a bias for further sterling weakness. But it recovered to reach a one-week high.

Some analysts have argued the Conservatives' failure to secure a majority might weaken the case for a "hard" Brexit, in which Britain leaves the EU's single market and customs union, a matter of deep concern for businesses. Talks begin on June 19.

"Clearly political uncertainty is the overriding theme here, this is why sterling dropped significantly on the exit poll last night," said Jane Foley, head of FX strategy at Rabobank.

"But the fact that it hasn't weakened as much as many commentators had anticipated I think can be attributed to the discussion about a soft Brexit."

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