Sterling recovers on "No" polls, volatility jumps

(Updates prices, adds more comment)

By Patrick Graham and Anirban Nag

LONDON, Sept 17 (Reuters) - Sterling crept above $1.63 to a two-week high on Wednesday, helped by polls showing the "No" camp holding onto a slender lead before Thursday's referendum on Scottish independence.

Tension remains high before the vote, and the cost of hedging against sharp overnight swings in the British pound doubled from Wednesday's European close. One-week options imply the highest levels of volatility since 2008.

That reflects how worried markets are that a vote for Scottish independence would weaken sterling and usher in months of financial and political uncertainty. But it also suggests expectations of a swift rebound if the vote is "No".

"We think by 8.30 a.m. (0730 GMT) on Friday, the pound could be back at $1.6850 if it goes the way the polls are now showing," said Adam Myers, European head of FX strategy with Credit Agricole in London.

He was also favoured the pound against the Swiss franc over the next three months, judging a weak euro will force the Swiss National Bank (NYSE: NBHC - news) to sell more francs and recycle the resulting euros into other currencies.

Until a turnaround in mid-July, sterling had been one of the best performers among major currencies in the past year, propelled by expectations robust economic growth would prompt the Bank of England to raise interest rates by early next year.

But a encouraging economic report on Wednesday - showing unemployment has fallen slightly more than expected - had only a brief effect on the pound, prodding it to its highest since Sept. 5. It was outweighed by the risks involved in Thursday's vote.

"Overall the numbers on the labour market were pretty good, but investors are staying on the sidelines until after the referendum," said Josh O'Byrne, a strategist with U.S. bank Citi in London.

SWINGS

Bankers' estimates of how much the pound could fall on Friday if the Scots vote to break up their 300-year old union with the rest of Britain range from the just over 3 cents against the dollar, implied by some options, to as much as 10 percent.

Overnight sterling/dollar implied volatility jumped to as high as 18.60 percent, having closed Tuesday at around 9.4 percent. The equivalent euro-sterling contract rose to 14.5 percent from Tuesday's close of 10.4 percent. The overnight options expire on Thursday as Scots vote.

"These polls have settled market nerves, and I think a lot of people are preparing themselves for a `No' vote," said a spot trader with one international bank in London. "If that happens obviously sterling will rebound, but clearly not as much as it will fall in the event of a `Yes'."

Further out, the outlook is less clear. Some analysts have talked of the referendum as a shock to the pound to rival the 2007-8 financial crisis or Britain's exiting the pre-euro exchange rate mechanism in 1992. Those events eventually led to sell-offs of 29 and 32 percent respectively.

On the other hand, think tanks and investment banks are increasingly sizing up how to adapt the Scottish financial system to independence.

Britain's London-based leadership agrees that Alex Salmond's nationalists cannot have the currency union they would ask for after a "Yes" vote. In that case, a number of bank analysts say the most likely outcome is a pegged currency arrangement.

A study from Swiss bank UBS - one of the world's biggest traders in foreign currencies - said Scotland would have to spend the equivalent of 58 percent of its gross domestic product on transition costs and establishing the currency reserves necessary for a peg. It put the cost of unilaterally adopting sterling as a currency lower, at 41 percent.

Those estimates were based on the assumption that Scotland, as Salmond has said, would threaten to walk away from its share of Britain's public debt in talks with London on the split.

UBS (NYSEArca: FBGX - news) economist Paul Donovan said the costs might be less if the two sides split amicably and tried to implement the new financial settlement with a minimum of market volatility. If the settlement is less amicable, he said, the figures might also be higher. (Reporting by Anirban Nag and Patrick Graham; Editing by Larry King)