Government borrowing costs in the UK have experienced a significant jump, with the effective interest rate on 10-year borrowing climbing to 5.13% on Tuesday, a level not seen since the 2008 global financial crisis. This surge in yields is largely attributed to heightened uncertainty surrounding the future of Prime Minister Sir Keir Starmer, following a wave of calls for his resignation after recent election results.
Financial markets have been navigating a turbulent period, with fears of rising inflation due to the ongoing conflict in Iran contributing to upward pressure on interest rates. However, the domestic political landscape has added another layer of concern for investors. The prospect of a leadership change within the Labour Party, coupled with perceptions of a potential for looser public spending under new leadership, has unsettled market sentiment.
Market Reaction to Political Instability
More than 75 Labour MPs have publicly called for Sir Keir Starmer’s resignation. Despite this pressure, the Prime Minister has urged his cabinet to ‘get on with governing,’ stating that the formal process for challenging a leader has not been triggered. Allies of Sir Keir have voiced their support following a recent cabinet meeting.
Analysts at Capital Economics have warned that a change at the top of the Labour Party could lead to further increases in UK borrowing costs and a weakening of the pound. They highlighted the UK’s ‘already fragile fiscal position,’ suggesting that investors will be highly sensitive to any indications of fiscal loosening. The firm indicated that potential successors to Sir Keir Starmer and Chancellor Rachel Reeves, such as Andy Burnham, Angela Rayner, and Wes Streeting, are perceived as likely to ‘raise public spending,’ which could lead to increased government borrowing.
Governments typically fund expenditure exceeding tax revenue through borrowing, issuing bonds or gilts. Investors, in turn, seek certainty and confidence in returns when lending to governments. The recent rise in borrowing costs across various maturities – two, five, 10, and 30-year terms – reflects this diminished confidence. The yield on 30-year bonds reached 5.80%, its highest point since 1998.
The 10-year gilt serves as a benchmark for government bonds, while shorter-term gilts, such as the two and five-year maturities, influence fixed-rate mortgage rates. The UK’s primary stock index, the FTSE 100, saw a decline of 0.5%, with shares in British banks particularly affected by concerns over potential tax increases under a new administration. The pound also depreciated by 0.5% against the dollar, trading at $1.35.
Global and Domestic Pressures Converge
Anna Macdonald, investment strategy director at Hargreaves Lansdown, noted that elevated oil prices are adding inflationary pressure to a bond market already strained by concerns about potential shifts in UK fiscal policy. She explained that if a new prime minister were to adopt a different approach to borrowing, potentially relaxing fiscal rules, overseas buyers of UK government bonds – who constitute approximately 25-30% of the market – would demand a higher risk premium.
The cost of servicing existing public debt, which is linked to inflation and bond yields, has been escalating. This expenditure now accounts for roughly £1 in every £10 of government spending. While all governments have experienced rising borrowing costs since the conflict in Iran began, the UK has seen its rates increase more significantly compared to countries with similarly sized economies, underscoring the impact of domestic political uncertainty.
Prime Minister Starmer and Chancellor Reeves have consistently emphasized their commitment to ‘iron clad’ borrowing rules to assure markets of their economic plan’s credibility. However, the current political climate suggests that these assurances are not fully assuaging investor concerns, leading to a higher cost for the government to borrow money.
