UK’s latest political standoff threatens to put a ‘Damocles sword’ over Britain’s bond market, investors warn

UK Prime Minister Keir Starmer is defying calls for his resignation, but an analyst has warned of a “Damocles sword” hanging over the influential bond market until it’s clear who will succeed him.

Pressure mounted on Starmer amid criticism of his decision in 2024 to appoint Peter Mandelson as ambassador to the U.S. despite Mandelson’s links to disgraced financier and sex offender Jeffrey Epstein.

The release of millions of new emails and files related to Epstein cast new light on Mandelson’s relationship with Epstein, who died in prison in 2019.

Government borrowing costs jumped on Monday, as key members of Starmer’s team quit and a senior politician from his own Labour Party called on him to go.

By Tuesday morning — after loyalists rallied around Starmer — the yield on the benchmark 10-year gilt was 2 basis points lower at 4.509%, while the 30-year gilt yield was down 3 basis points to 5.319%. One basis point is equal to 0.01%, and yields and prices move in opposite directions.

The prospect of a leadership challenge that could upend the policy path laid down by Starmer and his finance minister, Rachel Reeves, poses a significant risk to gilt investors, market watchers said.

If Starmer stands down, or if a challenger secures enough support to challenge, it triggers a leadership contest that could take weeks.

Jordan Rochester, head of FICC strategy at Mizuho EMEA, said in a Monday afternoon note that, if a leadership contest is triggered, it could make gilts “subject to the whims of random political headlines” as the search for a new leader drags on.

“We may not see any movement from Starmer this week and by next week we’re back to trading CPI and PMI releases as usual,” Rochester said in his note. “But ultimately for many in the market it’s just a matter of time, with the local elections likely to see Starmer’s Labour party suffer at the polls. It’s a Damocles sword hanging above gilt traders until the question as to ‘who’s next?’ is finally resolved.”

Some local councils across the U.K. will hold elections later this year.

Kallum Pickering, chief economist at Peel Hunt, told CNBC’s “Squawk Box Europe” on Tuesday that the bond market would prefer Starmer and Reeves to remain in their positions.

“Timing is important in politics — Labour seem to be mystified and terrified of the bond market in equal proportions,” he said of the governing party.

“The thing that Westminster doesn’t understand that markets do, is that when it comes to fiscal policy, the issue for an advanced, rich country like the UK is not the debt or the deficit, it’s inflation. The UK is an inflation outlier. That’s why we pay the premium in the bond market. It’s not an outlier on debt or deficit.”

He said that a “big headache” for the bond market will be relieved when inflation likely cools in the coming months

“I think Starmer will be slightly surprised at just how much bond yields come down,” Pickering told CNBC. “Labour will be too, and they’ll say, well actually this is a prime minister that is now pretty safe for a while — so I think he squeezes through.”

Charlie Lloyd, head of investments at Shackleton Advisers, said on Tuesday that a leadership contest would “almost certainly” lead to short-term volatility in UK bond markets and an increase in the cost of borrowing through higher yields.

“A prolonged contest could impact the economy if gilt yields traded at a premium to other bond markets for an extended period, not to mention the potential impact on consumer confidence.”

In the past, bond markets have signaled support for Reeves’ self-imposed fiscal rules, which state that day-to-day government spending must be funded by tax revenues and not borrowing, and public debt must be falling as a share of economic output by 2029-30.

When Reeves’ political future was in doubt last summer, gilt yields spiked as much as 22 basis points in a single day, with market watchers saying at the time that investors were concerned her departure would lead to the government spending and borrowing more.

Among Starmer’s potential replacements are left-leaning Angela Rayner, who resigned as deputy prime minister last autumn after a tax scandal, Health Minister Wes Streeting and former Labour Party leader Ed Miliband.

Lloyd said much of the jitters rippling through gilt markets was arising from concern about potential successors sitting politically to the left of Starmer, such as Rayner and Manchester Mayor Andy Burnham.

If a replacement is in the job before June, they will be the UK’s sixth prime minister in 10 years.

In 2022, gilt markets were shaken when then-Prime Minister Liz Truss announced a swathe of unfunded tax cuts — forcing an intervention from the Bank of England and leading to Truss’ resignation after just 44 days into the job.

The UK has the highest long-term borrowing costs of any G7 nation. Among those nations’ 20- and 30-year bonds, only the UK’s have a yield above 5%.