Even as Keir Starmer vowed to fight on as prime minister, Britain is facing a politically perilous moment.
At least that’s what the bond markets are saying.
On Tuesday, the British pound and the price of government bonds dropped as a rebellion within the governing Labour Party gathered pace to push Mr. Starmer out. The pound fell 0.5 percent to $1.35. Bond yields, which move inversely to prices, jumped. The benchmark 10-year yield climbed to 5.12 percent, up from 5 percent on Monday evening, a sizable move. The yield stayed at that level later in the day after Mr. Starmer said he would get on with governing. But resignations from members of his team continued.
In British politics, the bond market has come to hold huge sway. The premiership of Liz Truss was cut short in 2022 amid convulsions in the bond market after investors balked at her borrowing and spending plans. This time, that market has signaled support for Mr. Starmer and his government’s intentions to bring down debt levels by sticking to ironclad fiscal rules.
But uncertainty over how long Mr. Starmer will retain his position is adding strain to the bond market. The rising yields signal concern that a new political leader might be tempted to borrow more to pay for more spending and investments.
“Because it is unclear who is most likely to succeed Starmer and the policies that they would pursue, investors are likely to attach a risk premium to U.K. assets until the uncertainty is resolved,” Andrew Wishart, an economist at the bank Berenberg, wrote in an note.
He added that members of the Labour party, if given the chance, would be more likely to choose a more left-leaning successor. “Pursuit of a further-left policy agenda risks” measures that could push the economy closer to slower growth, higher interest rates and even an exodus of capital from the British economy, he wrote.
But several economists have noted that while political instability is harmful for British financial assets, the war in the Middle East has a bigger economic impact.
The rebellion against Mr. Starmer was set off by his party’s poor performance in local elections across Britain last week. But even before then, the yields on government bonds were rising sharply. These moves were greater than moves in the giant U.S. bond market, as well as in the yields of many of Britain’s European neighbors. The conflict in the Middle East was expected to worsen an already challenging economic and fiscal outlook in Britain.
Inflation in Britain was stubbornly high and just as it was expected to fall, the war in the Middle East sent global energy prices surging. Britain is now facing higher inflation and slower economic growth this year. Investors are now betting that the central bank will raise interest rates instead of cutting them this year, in turn raising borrowing costs for mortgage holders, businesses and the government. All of these lead to a more constrained financial outlook and make it harder for any leader to pursue quick economic growth.
An ouster of Mr. Starmer and his top financial official, Rachel Reeves, would lead to higher yields on British government bonds, known as gilts, and overall interest rates, analysts at Capital Economics concluded in a recent report.
“We doubt a new leadership would be any more successful at boosting medium-term economic growth either, not least because the current fiscal constraints would remain,” the Capital Economics analysts wrote. “For the gilt market, though, the war in Iran matters more.”
With Britain facing a higher inflation outlook and political uncertainty, 10-year bond yields at 5 percent “are here to stay,” said Andrew Goodwin, an economist at Oxford Economics.
