The vote opens up a range of outcomes, including no deal, a renegotiation of Mrs May’s deal, or a second referendum.
Sterling rose 0.05% to $1.287 after declines of more than 1% earlier in the day.
The currency slumped 7% in 2018 reflecting uncertainty about the terms of the UK’s exit from the European Union.
MPs voted by 432 votes to 202 to reject the deal, the heaviest defeat for a sitting government in history.
The Chancellor Philip Hammond and the Business Secretary Greg Clark telephoned business leaders immediately after the vote to attempt to assure them that a Brexit deal was still achievable.
“A defeat has been broadly anticipated in markets since the agreement with the EU was closed in November 2018 and caused several members of the government to resign,” said Richard Falkenhall, senior FX strategist at SEB.
But business groups said their members’ patience was wearing thin.
“There are no more words to describe the frustration, impatience, and growing anger amongst business after two and a half years on a high-stakes political rollercoaster ride that shows no sign of stopping,” said Adam Marshall, director general of the British Chambers of Commerce.
He implored MPs to come to an agreement, and was joined in this plea by business groups including the Federation of Small Businesses, the Institute of Directors and the Confederation of British Industry.
Some investors see the chances of a no-deal Brexit diminishing as parliament exerts more authority over the process.
If a no-deal hard Brexit comes to pass, ING predicts sterling would tank to $1.12 and hit parity with the euro.
Some market watchers suggested that traders were anticipating a major government reversal of policy in the wake of the historic defeat for Ms May.
“Traders are seemingly taking the outcome as paving the way for an extension of the Article 50 deadline, rather than increasing the chances of a no-deal Brexit and this has caused the recovery seen in the pound,” said David Cheetham of XTB.
“Sterling has pared its earlier loss – this is not surprising. It raises the chances of a ‘no Brexit’ or, at the least, an extension of Article 50,” said Seema Shah of Principal Global Investors.
“Admittedly, the chances of a no-deal Brexit may mathematically have also risen, but the market remains ever-hopeful that the government will not commit an error of such epic proportions.”
But others suggested that the volatility was inevitable given the huge political uncertainty and the increased risk that the Government could fall.
“A confidence vote loss is not a sterling positive; international investors will see it as a negative for the pound given the uncertainty over the Labour party’s Brexit position and what a Corbyn government would mean for the UK economy,” said Jeremy Thomson-Cook, Chief Economist at WorldFirst.
“Sterling is living on borrowed time and could benefit from the government ruling out no-deal.”
Carolyn Fairbairn, the CBI director general, said that Ms May now needed a “new plan”.
“Every business will feel no deal is hurtling closer. A new plan is needed immediately,” she said.
“This is now a time for our politicians to make history as leaders. All MPs need to reflect on the need for compromise and to act at speed to protect the UK’s economy.”
“As things stand, UK law says we will leave on 29th March, with or without a withdrawal agreement, and yet MPs are behaving as though they have all the time in the world – how are businesses meant to prepare in this fog of confusion?” said Stephen Martin of the Institute of Directors.
“The probability of a no deal has diminished while the chances of a delay in Article 50, a second referendum or even, at the margin, no Brexit at all, have all increased. The consequence of those scenarios has encouraged sterling to rally despite the PM suffering the worst parliamentary result in a century,” said Jeremy Stretch of CIBC Capital Markets.
On Friday, hedge fund manager Crispin Odey, a major donor to the Brexit campaign, said he now expected the project to be abandoned altogether and that he is positioning for the pound to strengthen.