UPDATE 6-Sterling drops, FTSE set to gain after UK election shock

* Sterling falls as much as 2 percent after exit poll

* Steadies thereafter, now down 1.5 pct on day vs euro, dollar

* FTSE futures fall, gilt prices point to safety bid

* To see a Reuters interactive graphic on the election polls and results, click on http://tmsnrt.rs/2q7tC48 (Adds early London trade, confirmation Conservatives lost majority)

LONDON, June 9 (Reuters) - Sterling saw its biggest daily fall since January before recovering some ground on Friday after a shockingly bad election result for Prime Minister Theresa May plunged Britain into political chaos days before the start of Brexit talks.

The surprise of a result that raises questions about how Britain will advance with its plan to leave the European Union, and whether any party can form a stable government, initially sank the pound by 2 percent against both the dollar and euro.

But with results still pointing to May's Conservatives forming a minority government, and analysts playing up the chances of a "softer" Brexit under that or an alternative left-wing coalition under Labour leader Jeremy Corbyn, the pound then steadied.

British gilt yields fell as investors sought the security of government bonds in the face of the uncertainty while London's main FTSE stock exchange indices flipped into positive territory after overnight losses.

"Weve got a winner but dont expect the celebration bells to be ringing," said ThinkMarkets analyst Naeem Islam.

"This is not the kind of outcome which investors were looking for. Although Theresa May has won the election, in reality, it is Jeremy Corbyn who has made substantial progress. This clearly opens the way towards $1.22 in coming weeks."

By 0500 GMT, sterling was 1.5 percent lower on the day at $1.2753 - having fallen as low as $1.2693 - and 87.78 pence per euro.

Falls for sterling have tended to support London's internationally-focussed FTSE 100 blue chip index. With trading volumes still extremely thin, FTSE futures were up around 0.3 percent, having earlier fallen by a similar amount.

An up-to-5-percentage-point fall in gilt yields, however, suggested shocked investors would seek the security of bonds when markets reopened properly in London.

Mohamed El-Erian, chief economic adviser at Allianz, said: "With initial exit polls pointing to the Tories (Conservatives) losing seats and that Prime Minister Mays early election gamble is not paying off, markets are pricing in a more complex outlook for policy implementation, including Brexit."


The initial exit poll predicted the Conservatives, traditionally favoured by markets as pro-business and fiscally prudent, would win 314 seats in the 650-member parliament and the opposition Labour Party 266, meaning no clear winner and a "hung parliament".

Later projections gave the Conservatives a handful more seats but a raft of analysts predicted that would not head off more falls for the pound.

"While some have argued that a softer Brexit might ameliorate the downside, there is still the prospect of the contents of the Labour party manifesto," said Michael Hewson, chief analyst with CMC Markets in London.

"This could well see the pound come under further pressure as well as having consequences for the FTSE100 and FTSE250 when European markets open."

Investors' traditional views of whether the Conservatives or Labour would be good or bad for the pound, have been muddied in this election, not least by the prospect of Brexit talks due to start on June 19.

Some banks have said a high-spending Labour government could spur economic growth and cause the Bank of England to raise interest rates more quickly.

Some also argue that any Labour-led coalition might aim for a softer deal on Britain's planned departure from the European Union than the "hard Brexit" that markets have worried May would deliver.

"The pound is getting hit ... and that's probably a symptom of uncertainty," said Jason Ware, chief investment officer at Albion Financial in Salt Lake City, Utah.

"But if we get more of a softer Brexit or more of a globalist stance from the UK... it's good for Europe, the UK and U.S. assets." (Reporting by Noel Randewich, Richard Leong, Jennifer Ablan, Megan Davies and Dion Rabouin in NEW YORK, Patrick Graham and Helen Reid in LONDON and Masayuki Kitano in SINGAPORE; editing by Mark Trevelyan)