Reports of a move to oust Prime Minister Keir Starmer, alongside fears of a disastrous Labour performance in Thursday’s local elections, have left gilt markets on edge.
Political instability puts gilt markets on edge
Investors remain deeply shaken by the Liz Truss mini-Budget crisis and are highly reactive to any signs of political or fiscal uncertainty.
Labour MPs are reportedly preparing an open letter aimed at pressuring Starmer to outline a timetable for stepping down, as forecasts indicate the party could lose up to 1,900 council seats. The pressure is being compounded by growing challenges from Reform UK and the Green Party.
As I was quoted by CNBC, Wall Street Journal, City AM, London Loves Business, Investor Ideas, and Proactive Investors, amongst other media, markets have long memories, and for the UK gilt market, that memory is still defined by Liz Truss.
The Liz Truss mini-Budget crisis remains the clearest example of what can happen when fiscal credibility comes under scrutiny. Bond yields spiked, long-dated gilts suffered the most severe losses, and the Bank of England was forced to intervene with emergency measures to restore market stability.
Investors are now assessing current political developments through the same lens, remaining highly sensitive to any signs that could undermine confidence in the UK’s fiscal or political stability.
Lessons from the Liz Truss market shock
The UK is approaching this political flashpoint with very limited room for error. Public debt remains close to 100% of GDP, government borrowing is still running at high levels, and gilt issuance is projected to top £250 billion during the current fiscal year.
At the same time, economic growth remains fragile, leaving the country’s fiscal outlook highly vulnerable to even modest changes in policy direction or investor confidence.
If Labour endures a severe electoral setback and internal party divisions deepen, gilt markets are likely to begin pricing in a greater risk of looser fiscal policy, whether through higher public spending, weakened fiscal rules, or political compromises aimed at easing pressure within the party.
Attention is expected to focus on the long end of the gilt curve, where maturities of 10 to 30 years are especially vulnerable to concerns over rising supply and the sustainability of the UK’s long-term fiscal position.
The long end is where the damage emerged during the Liz Truss mini-Budget crisis, and it is where it would likely appear again. When investor confidence weakens, markets demand a higher term premium, which can push yields sharply higher across those maturities.
During the Liz Truss mini-Budget crisis in 2022, 30-year gilt yields briefly climbed above 5%, placing intense strain on liability-driven investment strategies widely used by pension funds. The sharp market repricing ultimately forced the Bank of England to intervene with emergency gilt purchases to avert a wider financial stability crisis.
Sterling and bond markets move in tandem
The episode fundamentally reshaped how investors assess UK risk, leaving markets far more sensitive to signs of fiscal or political instability.
A sudden loss of confidence can spread through the financial system far more quickly than policymakers anticipate. Bond markets react to expectations, often repricing risk well before any concrete policy changes are implemented.
Sterling remains closely tied to these market dynamics. Any weakening in confidence caused by leadership uncertainty or a shift toward looser fiscal policy would likely put pressure on the currency, increasing imported inflation and adding to upward pressure on bond yields.
Currencies and bond markets tend to move in tandem during periods like this, as investors reassess both fiscal credibility and economic stability.
A weaker pound tends to raise inflation expectations, which in turn drives gilt yields higher. Once that process begins, it can quickly develop into a self-reinforcing cycle that becomes increasingly difficult for policymakers to contain.
Reports suggesting Labour backbench MPs are drafting an open letter to Keir Starmer, with parallels being drawn to the internal pressures that preceded the exit of Sir Tony Blair in 2006, are adding a further layer of political uncertainty at a sensitive time.
For investors, the key concern is governance and control. If Thursday’s results reveal deeper fractures within the government, attention is likely to shift beyond leadership questions to fiscal credibility, specifically whether Chancellor Rachel Reeves can continue to maintain firm control over spending and borrowing plans in a way that reassures markets.
The combination of a potentially significant electoral setback, coordinated internal pressure on Keir Starmer, and growing questions about whether Reeves can firmly anchor fiscal policy is being seen as a potential warning signal for UK bond markets.
If those pressures intensify after the vote, gilt investors are likely to react quickly, pricing in higher borrowing needs, demanding greater compensation for perceived risk, and pushing yields higher in a way the UK can ill afford.
To read my previous blog post, click here.