City economists and analysts are expressing concern that UK government borrowing costs could rise if the Labour Party engages in a leadership race this summer. The potential for higher bond yields stems from fears that a new leader, particularly Andy Burnham, might pursue increased borrowing to address the cost-of-living crisis.
Market Reactions and Analyst Views
Dan Coatsworth, head of markets at AJ Bell, suggests that gilt yields could continue to rise if current leader Keir Starmer does not step aside quietly. With 10-year and 30-year bond yields already higher, in line with other European government bonds, Coatsworth notes that Friday's movements reflect the risk of a contested leadership transition. However, he also points to external factors such as the setback in the US-Iran peace deal, which has pushed oil prices up and sustained inflation fears, directly impacting interest rates and bond yields.
According to Coatsworth, the bond market will closely monitor Burnham's chances of securing the top job and how he might steer Labour in a new direction. Burnham, now in a stronger position after a decisive by-election win, may outline policy changes that deviate from the current party line.
Understanding Bond Yields
Bond yields rise when the price of the bond falls, serving as a gauge for the cost of issuing new debt. On Friday morning, the yield on UK 30-year bonds increased by 8 basis points to 5.529%, marking the highest level since Tuesday but still below the 27-year high of 5.89% set in May.
Alexandros Xenofontos and Christopher Granville at TS Lombard note that gilts are constrained by the return of domestic political risk. They pose the question of whether the next Labour leadership will preserve the fiscal discipline of the Starmer-Reeves era, shift left through funded tax-and-spend policies, or begin testing fiscal rules.
Potential Scenarios
Neil Wilson, investor strategist at Saxo UK, sees signs that markets are already worrying about the by-election result. He highlights two key concerns: the uncertainty inherent in a leadership race and the likelihood of Burnham becoming Prime Minister, which could lead to a leftward shift in government policy. Wilson warns that multi-year highs on 10-year and 30-year yields may be tested again as Burnham sets out his policy ideals. However, he acknowledges that the macroeconomic backdrop has changed since early May, with lower inflation angst and fewer expected rate hikes by the Bank of England.
Wilson also considers the possibility that Burnham might call a snap general election if he replaces Starmer. AJ Bell's Dan Coatsworth adds that such a scenario could significantly worry the bond market. If Labour were to lose power to Reform UK, investors might demand higher rewards for backing the UK, leading to higher bond yields, a more volatile pound, and concerns over unfunded tax cuts putting pressure on government borrowing.
