The bond market’s verdict on UK political risk

While discussing reincarnation, the US political strategist, James Carville, famously said that he “would want to come back as the bond market. You can intimidate everybody”. With that in mind, let’s turn to UK politics, which have once again become rather noisy. 

At time of writing (Friday morning), it looks likely that we’ll have a leadership challenge in the Labour party, with former Health Secretary Wes Streeting, Greater Manchester Mayor Andy Burnham and possibly former Deputy Prime Minister Angela Rayner as potential challengers to Prime Minister Keir Starmer. The precise timing remains uncertain – Burnham needs to find his way back to parliament first – but the direction of travel seems pretty clear. 

These political shifts continue to have an impact on UK financial markets, particularly government bonds. We think the calculus breaks down like this. 

Firstly, oil prices have been an important driver for government bonds recently. Government bond yields globally have generally risen on concerns that higher oil prices will feed into higher inflation – and UK yields have followed suit.

As for UK politics, we think that bond investors would be more comfortable with Starmer or Streeting as Prime Minister, rather than Burnham or Rayner. Both Rayner and Burnham are generally more left-leaning politicians and would likely prefer to increase government spending. This would most likely result in more borrowing and less budget discipline. This has generally been taken more negatively by bond markets and has helped to push up the yield on UK government debt in recent weeks.

Earlier this year, Burnham was quoted as saying that the UK was still too “in hock to the bond market”. Some might consider that a call for Budget surpluses, but neither Burnham nor investors took it that way. 

Investors also have recent experience to draw on. The ill-fated Liz Truss premiership, in 2022, sparked a sharp rise in bond yields that have persisted since her departure, as you can see in the chart below. 

Leaving the politics to one side, it’s clear that the UK faces some fiscal challenges. Growth remains weak and inflation relatively high. Starmer and Chancellor Rachel Reeves came into office stressing the need for stronger growth to free up more fiscal resources – but that’s proven difficult to achieve, as their predecessors also discovered. 

In some respects, the UK fiscal situation isn’t terrible, compared to Developed Market peers. The chart below shows government debt as a percentage of GDP for a range of countries it’s not a definitive answer, but it does give a snapshot. Among these peers, only Germany has a significantly lower level of debt to GDP, while the sharp improvement in Greek debt metrics, albeit from very high levels, is also notable. 

There are a couple of specific challenges that are often made about the UK. For instance, it has a relatively high level of inflation-linked debt – perhaps 20% of the total. So, an inflation shock increases the interest payments that the government must pay on that debt quite quickly. Also, domestic pension funds are holding less UK government debt than in the past, making the UK more dependent on foreign investors. 

Where does this leave us? Having sold long-dated gilts at the end of February, we are monitoring whether the rise in yields has created an attractive opportunity to re-enter the position. The macro backdrop and the political volatility are challenging, but somehow well-flagged.

The oddsmakers suggest that Keir Starmer probably won’t be Prime Minister at the end of the year, but we suspect that any new Prime Minister, and Chancellor, will have to deal with the realities of trying to fund additional spending. With 10-year yields above 5%, we think that longer-dated gilts are looking more attractive despite the volatile environment we could see.