Political pressure builds – and bond markets are watching

The latest UK political scandal has brought renewed attention to the link between politics and bond markets.

Recent reports suggest that Peter Mandelson, the former British ambassador to the United States, failed the security vetting process ahead of his appointment, only for the decision to be overruled. The subsequent departure of the Foreign Office’s Permanent Secretary, alongside questions around who knew what and when, has added to concerns around governance and transparency.

In this context, even relatively small market moves can be instructive. UK government bond yields rose slightly last Thursday, diverging from European peers. While a single day does not make a trend, it highlights how political developments can feed into investor sentiment.

It’s been well-documented that the UK government, and the chancellor in particular, faces a number of challenges. Starting government debt levels are relatively high. The tax burden is already the highest in a generation. The public is unhappy with the provision of public services like healthcare. 

On the political side, we’ve seen public dissatisfaction reflected in voting intentions. YouGov polling (“If there were a general election tomorrow, which party would you vote for?”) has shown a significant splintering of voting intentions – particularly for two parties (Reform and the Greens) with no track record in government. Reform currently leads voting intentions with 24%, the Tories at 19%, Greens at 18% and Labour at 17%. That might not matter if the current government seems stable, given that they don’t need to call an election before late 2029, but the Prime Minister’s future looks quite uncertain.

In terms of government spending, the dance between the chancellor and the Office of Budgetary Responsibility (OBR) is becoming more formulaic. Faced with a five-year forecast period, the Treasury presents an assumption of very low spending growth in years 3, 4 and 5, in order to reach its targets for debt sustainability – whatever they happen to be). This satisfies the OBR, and possibly bond investors in the short term. At the same time, we’ve seen that the government’s majority, which you might call sizable but ill-disciplined, doesn’t allow the chancellor to make any significant cuts to domestic fiscal spending. 

Finally, in terms of geopolitics, it looks – even though we’re certainly not military experts – like the ability of the UK military to project force is quite constrained and that calls for increased military spending will likely grow. For context, UK defence spending today is, as a percentage of GDP, about half of what it was in the 1980s.

So, where does this leave us? The Prime Minister is facing another tense period, between the latest revelations over Peter Mandelson and the prospect of difficult local elections in early May. Looking at prediction markets like Kalshi or Polymarket, we see that bettors reckon it’s 50-50 that Keir Starmer will still be in office in September. 

We think this sort of uncertainty will make bond investors wary. Most replacements for Starmer within the Labour party would probably like to spend more freely than the current administration, suggesting higher taxes or a larger deficit. We’d argue that some of this is already reflected in starting UK government bond yields, which are high compared to their developed market peers. But we’d still prefer to take our UK government bond exposure in shorter-dated bonds, rather than add to longer-dated positions that could face more volatility.