Renewed Political Turmoil Brings Fresh Downside Risks For Gilts And The GBP

Here we go again, then.

In about a decade of doing this, I reckon I can count on two hands the number of days that markets haven’t been worried, in some shape or form, about the UK political backdrop. Of course, the magnitude of that worry has waxed and waned over time, though it’s safe to say that political jitters are once again on the rise, as PM Starmer’s future looks increasingly uncertain.

Mandelson – The Straw That Could Break The Camel’s Back

To recap – the PM has been on shaky ground for some time, though pressure on his position has increased considerably in light of recent allegations surrounding former US Ambassador Peter Mandelson, which in turn has called into question the PM’s judgement in having appointed him to the role. Starmer’s position, from a political perspective, has been further weakened by the weekend resignation of Chief of Staff Morgan McSweeney, as well as speculation that Cabinet Secretary Sir Chris Wormald may also be moved on.

The key difference between the present situation, and the range of other U-turns that the government has made to date (business rates, winter fuel payments, digital ID, etc.), is that this matter concerns the PM’s own judgement, and own decision to appoint Mandelson to his role. Not a matter that was handled by a Committee, or another department, somewhere else in Whitehall, but in the PM’s study at the heart of Downing Street. Hence, this becomes a considerably harder storm for Starmer to weather.

GBP Assets Reprice Political Risk

Markets, unsurprisingly, have reacted in rather dismal fashion, though moves thus far are relatively contained in the grand scheme of things. Gilts have not only started the week with a notable bout of weakness at the long-end of the curve, but also by underperforming DM peers, resulting in the yield spread over that of benchmark 10-year Treasuries having widened out once more.

The pound also trades softer, not only against the greenback, but more notably in the crosses, while sentiment in the options complex has soured notably, with 1-, 3-, 6- and 12-month cable risk reversals having all flipped to show puts trading at an increasing premium to calls. Of course, there is something of a ‘double-whammy’ going on here, with not only political uncertainty, but also last week’s dovish BoE decision exerting pressure.

Regardless, from a narrative perspective at the very least, it is political developments that are clearly dominating. On that front, participants will not only be paying close attention to how the situation pans out this week, but also to the upcoming Gorton & Denton by-election on 26th February, which is likely to prove a key ‘litmus test’ for PM Starmer, followed by local elections – which are likely to be something of a bloodbath for the Labour party – on 7th May.

Lack Of Successor Buys Starmer Some Time

Perhaps the most notable, or even only, factor that is preventing an imminent leadership challenge is the lack of a credible and well-positioned successor.

In terms of ‘runners and riders’, former Deputy Leader Rayner is by far the most popular with Labour members, though an ongoing dispute over whether the correct tax was paid on a property purchase has called her credibility into question. Meanwhile, Manchester Mayor Andy Burnham, another figure popular with the left of the party, is not yet an MP, ruling him out of any imminent leadership challenge; Health Secretary Wes Streeting faces potentially tricky questions over his past associations with Mandelson; and, Energy Secretary Ed Miliband must grapple with the difficulty of having already been Labour leader, and having lost a general election in 2015.

Unless and until one of these, or another, challenger is able to build a credible case of their own, and obtain the support of more than 80 Labour MPs to trigger a formal leadership challenge, the PM is likely to continue ‘muddling through’. That said, the prospect of enacting any significant policy proposals, or furthering the progress of any major legislation, during such a period is so remote as to be non-existent, likely resulting in a potentially prolonged period of political inertia. To be clear, this inertia, Starmer’s lack of political capital, and the likelihood that further details of the Mandelson affair come out in the wash, all point to this being his leadership being unsalvageable, no matter how long it takes for a successor to emerge.

Stronger Bear Case For UK Assets

For UK assets, this political uncertainty would be enough of a headwind on its own. However, compounding issues is the knowledge that, whenever a leadership election is triggered, and whenever a successor is appointed, that successor is likely to not only be further towards the political left than the current Starmer/Reeves duo, but also seek to run considerably looser fiscal policies. One of the first moves that a new Chancellor is likely to make will be to tweak the current set of fiscal rules, and further water down the role of the OBR, while touting sizeable public spending increases, coupled with an even-higher tax burden.

A repricing of this fiscal risk premium, which markets had steadily priced out after last November’s Budget, is hence the biggest short- and medium-run downside risk to both Gilts, and to the GBP. At a time when incoming data has recently suggested that the economy may be starting to turn a corner, renewed chaos in Westminster is likely to slam the brakes on any bullish UK narrative, before its gathered any pace at all.