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By Patrick Graham and Sudip Kar-Gupta
LONDON, May 8 (Reuters) - Britain's pound, 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 world's fifth-largest economy and British asset prices.
Cameron has pledged to hold a referendum on 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 in London.
"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.
"We don't do Labour, Lib Dem or UKIP here. Celebratory breakfast, lunch and drinks tonight," said one London-based equities trader. "Great news for the UK."
Opinion polls had consistently shown the two main parties running neck and neck, with neither expected to secure a parliamentary majority.
Sterling posted its biggest daily rise against a trade-weighted basket of currencies in five years, gaining 1.7 percent.
The pound was up 1.5 percent against the euro, pushing the single currency down to 72.715 pence, and up 1.4 percent against the dollar at $1.5459. It had risen above $1.55 for the first time since late February, before settling back later in the day.
The FTSE 100 index closed up 2.3 percent at 7,046 points, close to the record 7,122.74 points it touched last month, led by banks, utilities and property shares.
The FTSE 250 mid-cap index, which is more closely tied to the British economy, reached a record 18,161 points.
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 last trading at 1.88 percent, down around 6 basis points, at 1545 GMT.
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.
"We know that this government is going to keep its pedal on austerity, and the last budget forecast spending cuts of 30 billion pounds by 2017/2018," said Jane Foley, senior currency strategist at Rabobank in London.
"And bearing in mind that CPI inflation is flat and inflation expectations have moderated over the last couple of months, I still don't think the Bank of England is going to have any real reason to hike interest rates soon." (Reporting by Patrick Graham, Jemima Kelly, Sinead Cruise, Francesco Canepa, Sudip Kar-Gupta and Jamie McGeever; Writing by Jamie McGeever; Editing by Catherine Evans)