The pound rallied to a session high above $1.50 after London's Evening Standard newspaper reported Prime Minister Gordon Brown was set to resign, possibly as soon as Tuesday night, after talks aimed at a Labour/LibDem coalition failed.
Both of the major parties have been trying to win round the Lib Dems, but senior Labour figure Ed Miliband said on Tuesday afternoon the talks between his party and the Lib Dems were "temporarily" over, fueling speculation they had broken down.
Prime Minister Gordon Brown's office denied a report that he had already resigned.
"Any signs that there will be a conclusion to the negotiations for a new government will likely give sterling a boost, and that's probably what we're seeing here," said Chris Gothard, currency strategist at Brown Brothers Harriman.
Gilt futures reversed deep early losses to settle 40 ticks up at 116.58 while the 10-year gilt/Bund yield spread narrowed sharply to after earlier hitting a session high above 110 basis points.
Britain's FTSE 100 index of leading shares ended one percent lower, but off session lows.
Markets want a quick resolution to uncertainty and favor a Conservative-led government because they believe it would move faster to cut Britain's budget deficit.
The Conservatives won most seats in Britain's parliamentary election last week but fell short of a majority, prompting days of political wrangling that dimmed the appeal of UK assets.
Brown said on Monday he would stand aside this year in an attempt to give his party a better shot at forming a coalition.
