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UPDATE 3-Pound's "flash crash" strains bond, stock market nerves

* Algo-driven flash crash leaves sterling 2.5 percent lower

* Political pressure on currency continues to build

* FTSE 100 benefits, mid-caps suffer

* Gilt yields surge as inflation expectations rise

* Worries over twin deficits in background

* For graphic, click tmsnrt.rs/2dAcyM6 (Adds quote, FTSE close)

By Patrick Graham and Kit Rees

LONDON, Oct 7 Sterling lost as much as 10 percent of its value in just a few minutes of trading early on Friday, a "flash crash" that fuelled concerns about the vulnerability of the currency and other British assets to investor worries about Brexit.

The pound recovered from the initial plunge, which took it as low as $1.1491 in Asian hours and was driven, dealers said, by the automated algorithmic computer trades that now dominate the global foreign exchange market.

But selling by European and U.S. investors quashed any bounce as first London then New York came on line, driving a 2 percent loss on the day and putting sterling on course for its biggest weekly fall since 2009.

The fall in sterling sounded like good news to investors in internationally focused UK firms, which gain on overseas revenues and competitiveness when the currency falls. The FTSE 100 index was up 0.6 percent at its close, led by mining companies and Asia-exposed banks Standard Chartered and HSBC while other European stock markets fell sharply.

But there are growing worries about the impact sterling's losses and the Brexit nerves behind them will have on domestic demand, inflation and economic growth in the years ahead.

Ten-year gilt yields rose by as much as 11 basis points to 0.984 percent, the highest since the week of the referendum vote to leave the European Union in June.

The FTSE 250 index of medium-sized UK firms, typically more dependent on the domestic market, marked its third straight session of losses after hitting an all-time high on Tuesday.

"This is the first sign in a couple of months that there is some market concern about a Brexit," said Jonathan Roy, advisory investment manager at Charles Hanover Investments.

"What we're seeing playing out is domestic-facing stocks weakening in the face of a potentially 'hard' Brexit ... while we're seeing strength in the FTSE 100."

HEDGING COSTS

Sterling has been falling steadily for a fortnight, as investors fret that the government's intention to prioritise immigration controls over access to the single market in exit talks will spark deeper cuts to foreign investment in Britain.

So far, pension funds and other long-term fund investors have responded by buying UK shares and other assets while hedging the currency risk through options and other derivatives that allow them to sell the pound.

That may change if the currency proves too volatile to allow them to fund those trades, and measures of implied market volatility surged on Friday to more than 10 percent for durations out to a year.

Retailer Sports Direct said the overnight move in sterling, after it had entered into a hedging agreement to protect against weakness in the pound, led to a 15 million pound dent in its full-year earnings forecasts.

"If the rate is $1.20 on average for the remainder of FY17, then the negative impact ... would be in the order of a further 20 million pounds," it said. Shares in Sports Direct dropped over 9 percent, its biggest daily loss since the June 23 vote.

SAFE HAVENS

Against the euro, the pound fell more than 2 percent to 90.23 pence, its lowest in almost seven years after moves overnight that mirrored those versus the dollar.

Sterling-denominated gold rose to its highest since mid-July at 1,059.06 pounds an ounce overnight, despite spot gold prices dropping more than 5 percent this week.

Foreign investors overall hold half of all UK stocks and around a third of gilts, totalling more than $2 trillion.

The fear that the value of returns on those assets will be eroded steadily by inflation showed up in pricing of forward interest rate swap agreements, which rose to imply a rise in long-term inflation to 3.64 percent.

Before Friday's events, forecasts for the bottom of the pound's fall had generally been around $1.20-1.25, with the caveat that there is no technical support between there and all-time lows just above parity with the dollar.

HSBC strategist David Bloom forecast a fall to $1.10 by the end of next year.

"Sterling used to be a relatively simple currency that used to trade on cyclical events and data, but now it has become a political and structural currency," he said.

"This is a recipe for weakness given its twin (budget and current account) deficits. The currency is now the de facto official opposition to the government's policies."

(Additional reporting by William Schomberg, Atul Prakash, Sudip Kar-Gupta, Kit Rees, John Geddie and Anirban Nag; Editing by Catherine Evans)

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