By Patrick Graham and Jemima Kelly
LONDON (Reuters) - Sterling headed for its biggest one-day fall in David Cameron's six-year premiership on Monday, hit by a rise in the odds of a "Brexit" after London's mayor and other senior ruling Conservatives joined the campaign to leave the EU.
Mayor Boris Johnson's announcement on Sunday that he would support an exit from the bloc was seen as giving the "leave" campaign a much-needed figurehead. It drove a more than 2 percent fall in the pound versus the dollar and weakened government bond prices.
Helped by a brighter global mood, however, British blue-chip share prices rose to a three-week high (FTSE), with a cheaper pound seen helping exporters.
Sterling hit its weakest level in seven years at $1.4057
"Boris has upset the apple cart in going against his party leader," said ETX Capital currency trader Richard Wiltshire, in London. "Everyone is now thinking it's going to be a much closer-run thing than we previously thought."
"From now until the election, sterling will ebb and flow on the polls, but I think the uncertainty will weigh until we get the vote and any rallies in sterling will be used as an opportunity to sell it."
A number of bookmakers have shortened their odds on a Brexit since Friday, with some now putting the chances as high as 7/4, or 36 percent.
Ratings agency Moody's said it would consider shifting the outlook on Britain's credit rating to negative if Britons voted to leave Europe. Analysts from the world's biggest currency trader, U.S. bank Citi, told clients the chances of a Brexit had risen to 30-40 percent, from 20-30 percent before the weekend.
"Until now, the Brexit side has lacked the backing of one of the heavyweight figures in UK politics," Citi's chief UK economist Michael Saunders wrote. "That has now changed with the backing of (Justice Secretary Michael) Gove and, in particular, Johnson."
The cost of hedging against falls in the exchange rate shot up to its highest in more than four years
Against the euro (EURGBP=D4), sterling's falls were more modest: 1 percent on the day. The euro fell 1 percent against the dollar, on fears that a Brexit could damage the euro zone.
Concern over Britain's possible departure from the EU have been at the heart of a fall in sterling since November and several banks are now talking up the chances of a slide to as weak as $1.30.
STOCK SPLIT
Beyond the currency, the impact on business, banking and policy of a four-month run-in to the June 23 referendum looks more nuanced.
Some banks have raised the prospect of the Bank of England (BoE) cutting record-low interest rates further to offset any damage to economic growth in the short-term.
That might weaken the pound but could further inflate the value of other assets seen as well-insulated against the negatives of a Brexit, including stocks.
U.S. bank JP Morgan recommended buying British exporters against domestically focused companies and blue-chip stocks over smaller-cap stocks, which have less of an international focus.
"In the event of the UK leaving, the initial knee-jerk impact on the market could be quite negative," it said. "But we believe the resulting weakness of sterling and the BoE action will cushion a chunk of the fall in equities."
The FTSE 100 index closed up 1.5 percent (FTSE) but the smaller-cap FTSE 250 (FTMC) gained less - around 0.8 percent.
The biggest faller among British blue chips was housebuilder Berkeley Group Holdings (L:BKGH), whose shares slid by almost 5 percent as investors were unnerved by the prospect of a hit to UK house prices. The firm said in December the capital would need fewer new houses in the event of a Brexit.
British banking stocks closed higher (FTNMX8350), resisting the prospect they would be hurt by any threat to their operations in London from an exit from the EU.
"We expect UK markets to be volatile over coming days as the campaigns step up a gear, but our central case remains that the UK population will decide to remain in the EU," UBS economists Dean Turner and Bill O'Neill wrote in a note.