Bonds in for bumpy ride as Burnham's path back could prolong UK political turmoil

(Sharecast News) - The prospect of a prolonged Labour Party leadership battle saw a spike in bond yields, falling stock markets and a weaker pound on Friday amid fears that a political shift to the left could see looser fiscal policy. With Prime Minister Keir Starmer's grip on power loosening by the day, analysts were pointing to the potential return to parliament of former Cabinet minister and current Greater Manchester mayor Andy Burnham as a sign that public spending could rise under a new administration.

Burnham, previously blocked by Downing Street from finding a parliamentary seat, confirmed he would ask Labour's ruling national executive committee to allow him to stand in the contest. Allies of Starmer confirmed that he would not seek to block him.

The former health secretary will fight the Makerfield seat in a by-election after sitting MP Josh Simons said he would stand aside. Meanwhile, Health Secretary Wes Streeting, who quit on Thursday, saying he no longer had confidence in Starmer, had not launched a challenge but supported Burnham's return.

Seen as a threat to fiscal prudence by the so-called bond market "vigilantes", Burnham has previously said the UK need to stop being "in hock to the bond markets".

Yields on British government bonds - already elevated due to the country's disproportionate exposure to inflation and energy costs - rose to 30-year highs on the possibility of him winning any leadership contest.

"The 10-year yield is now close to the 2007 peak, if we break above 5.2%, currently yields are 5.16%, that would be a significant milestone and could drive 10-year yields to their highest level since the 90s. Back then the UK 10-year yield peaked around 6.5%, which was not a comfortable place for the country to be in," said XTB research director Kathleen Brooks.

However, UK bonds - also known as gilts - were not the only ones under pressure, with German, Italian and French bonds also feeling the heat amid inflationary fears as the Iran war pushed up energy prices and increased the chances of central banks lifting interest rates.

RISK PREMIUM FOR GILTS

Brooks argued that there was a "clear political risk premium in the UK market, and UK yields have broken away from the developed market pack".

"The 10-year yield is significantly higher in the UK compared to our peers. The market is facing more months of political chaos, this time under the Labour Party. The risk is that a prolonged battle, one of the candidates is not even an MP yet could lead to a race to the bottom, driven by the hard left of the Labour Party membership."

Others argued that whoever takes over would be forced to face the reality of a debt-to-GDP ratio of 93.8% and large interest repayments, so a sudden splurge in spending was unlikely.

"A new leader would operate under the same constraints; a significant increase in borrowing to fund additional spending is therefore not our base case," said Bill Papadakis at Lombard Odier.

"Political instability is not the dominant driver of higher gilt yields, which have been rising since the start of the Middle East conflict, as higher energy prices put a stop to Bank of England's easing cycle," he said.

"A gradual reopening of oil flows through the Strait of Hormuz would bring UK economic fundamentals and potential rate cuts back into focus, supporting our medium-term constructive view on gilts."

Reporting by Frank Prenesti for Sharecast.com