LONDON, May 8 (Reuters) - The pound, British shares and bonds rallied on Friday after Prime Minister David Cameron's Conservative Party won a shock election victory, removing immediate political uncertainty for investors who had expected a hung parliament.
The main FTSE 100 stock index surged towards last month's record high, while sterling chalked up its biggest gain against the euro in years and government borrowing costs fell.
But investors were also eyeing political and constitutional challenges resulting from the vote that have the potential to inflict damage on the British economy and asset prices.
Cameron has pledged to hold a referendum on Britain's membership of the European Union within two years, while the Scottish National Party's landslide victory north of the border may hasten another vote on independence there.
"A good general election result for the UK economy, but not a good day for the United Kingdom," said Richard Buxton, head of UK Equities at Old Mutual Global Investors.
"The scale of the SNP's victory in Scotland, together with the scale of UKIP's share of the national vote at over 12 percent, confirms the extent to which we are an increasingly divided nation."
The populist UK Independence Party, which favours withdrawal from the EU, surged into third place in the countrywide vote tally, although that translated into only a single seat.
Nigel Green, chief executive of deVere Group, said the rally in sterling, shares and bonds might be the calm before the storm, and advised clients to hedge themselves against a fall in the value of these assets due to political uncertainty.
"The prospect of an in-out referendum of Britain's EU membership has gone from risk to a reality," Green said.
The initial reaction across UK markets, however, was one of relief that there would be no hung parliament and that the Conservatives, who are generally perceived to be more market-friendly than the opposition Labour Party, were poised to win.
Opinion polls had consistently shown the two main parties running neck and neck, with neither expected to secure a parliamentary majority.
At midday in London, the FTSE 100 index was up 1.7 percent at 7,006 points, led by banks, utilities and property shares. The FTSE hit a record 7,122.74 points last month.
The FTSE 250 mid-cap index, which is more closely tied to the British economy, was up 2.9 percent, having hit a record high of 18,161 points earlier on Friday.
Sterling was up 1.5 percent against the euro, pushing the single currency down to 72.40 pence. Earlier, the pound had risen as much as 2 percent, putting it on course for its biggest one-day rise against the euro since early 2009.
The pound rose against the dollar above $1.55 for the first time since late February, before settling back to trade 1.2 percent higher on the day at $1.5430 at midday.
The yield on benchmark 10-year UK government bonds, or gilts, fell as much as 13 basis points at the open to a one-week low of 1.79 percent but was trading at 1.86 percent, down around 5 basis points, at midday.
The 10-year yield, which indicates the cost of borrowing for the British government, had touched 2.07 percent on Thursday, the highest since November last year.
The Conservative victory has potential implications for UK interest rates. If the government implements tighter fiscal policy than would have been the case under a coalition, the Bank of England may have room to keep monetary policy easy, which could take some of the wind out of sterling's sails.
"The Bank of England might need to keep rates lower for longer to maintain an equivalent amount of domestic demand," said Stephanie Flanders, chief market strategist for Europe at JP Morgan Asset Management.
"That, in turn, might be expected to produce a modestly lower pound." (Reporting by Patrick Graham, Sinead Cruise, Francesco Canepa, Sudip Kar-Gupta and Jamie McGeever; Writing by Jamie McGeever; Editing by Catherine Evans)