Speculation surrounding the future of Prime Minister Keir Starmer has ignited a fresh wave of market anxiety, prompting investors to offload the pound, UK equities, and long-dated government bonds. This political turmoil has created significant unease in financial circles, highlighting the delicate balance between economic stability and leadership credibility.
Gilt Yields Widen Amid Political Uncertainty
The gap between short- and long-term UK government debt, known as the yield curve, has surged to its highest level since 2018. This widening spread signals that investors are growing increasingly sceptical about the long-term health of the UK economy, even as the immediate interest rate outlook appears more favourable.
Yields on two-year gilts, which closely mirror Bank of England policy decisions, dropped sharply following the Monetary Policy Committee's decision to hold the Bank Rate at 3.75 per cent. This vote was notably narrower than many economists had anticipated, adding to the market's jitters.
Long-Dated Bonds Under Pressure
In contrast, interest rates on the 10-year gilt, a key benchmark for assessing a government's long-term borrowing capacity, remained stubbornly high. Investors are pricing in the possibility of a more fiscally expansive leader taking over from the current Prime Minister, leading to concerns about increased government spending.
The sell-off has pushed the gap between two- and 10-year bonds to over 95 basis points, marking the widest spread in nearly eight years. Traditionally, these bond prices move in tandem, but they become decoupled when confidence in the UK's inflation and fiscal outlook wavers.
Traders also reduced their holdings in the UK's 30-year coupon, the longest-dated bond with the weakest correlation to interest rates. Its yield climbed to the highest level since November, despite efforts by the government agency overseeing bond auctions to curb supply.
Sterling Suffers Parallel Decline
The pound experienced a concurrent sell-off, even before the Bank of England's interest rate announcement. Lower interest rates typically lead international investors to divest from a currency due to diminished yield prospects. Sterling fell by 0.86 per cent against the dollar, reaching its lowest point this month.
Only the Norwegian krone, which was heavily sold off amid declining oil prices, performed worse than the pound during this period. The FTSE 100 index also declined by 0.94 per cent over Thursday's trading session, with losses exceeding those seen on other major European blue-chip indices.
Market Experts Weigh In
David Zahn, head of European fixed income at Franklin Templeton, commented to City AM, "Long gilt yields remain tied to UK political risk. While we had anticipated political risk later in the year, it seems to be coming forward in the calendar. Gilts are beginning to price in a potential change in Labour government and the prospect of further fiscal loosening requiring additional gilt issuance."
Nigel Green, chief executive of Devere Group, added, "Rachel Reeves' credibility with bond markets has been built on one core thing: continuity. She's consistently positioned herself as a guardian of fiscal discipline, clear rules and predictability, particularly after the gilt market turmoil of recent years, especially during the Truss mini-Budget drama. This credibility is derived from the authority of the Prime Minister who empowered her and enforced discipline around the economic message."
Political Scandal Fuels Market Jitters
The market turbulence coincides with Keir Starmer being embroiled in a scandal involving his appointment of Peter Mandelson as US ambassador, despite Mandelson's connections to convicted sex trafficker Jeffrey Epstein. This controversy has left the Prime Minister's leadership on shaky ground, with several Labour MPs publicly demanding his resignation.
This fiasco has abruptly ended a positive period for major UK assets. Prior to Thursday, government borrowing costs had decreased by more than 20 basis points since September, alleviating some pressure on public finances. Additionally, the pound had strengthened earlier this year, buoyed by international investors shifting away from the dollar, and the FTSE 100 had achieved a series of record highs.
The sudden reversal underscores how quickly political instability can undermine economic confidence, with long-dated bonds and the pound bearing the brunt of investor concerns over future fiscal policies.
