Starmer's Political Crisis Sinks Pound and Gilts

Political turbulence is rattling UK markets, with fresh doubts over Prime Minister Keir Starmer’s leadership sending the pound and long-term government bonds tumbling on Thursday.

Investors are increasingly pricing in a political risk premium as Starmer faces mounting pressure over his decision to appoint Peter Mandelson as US ambassador, despite his known connection to the disgraced financier Jeffrey Epstein. The market fallout signals growing concern that the Prime Minister’s grasp on power is weakening.

UK Yield Curve Steepens as Pound Falters

The market reaction was swift and clear. Sterling dropped as much as 0.4% to a near two-week low of US$1.36, making it the worst-performing currency among its peers.

In the bond market, the yield on 10-year government bonds, or gilts, climbed by four basis points to 4.59%. Because shorter-term rates remained relatively stable, the gap between the two-year and 10-year gilt yields widened to 86 basis points—its most substantial spread since 2018.

Figure 1: The spread between UK 2-year and 10-year gilt yields surged to 86 basis points, its highest level since 2018, as political uncertainty spooked investors in long-term debt.

"It's worth keeping a closer eye on the UK with PM Starmer under considerable domestic pressure," noted Jim Reid, global head of macro research at Deutsche Bank AG. He added that the weakness in gilts reflects investor concern that "he could be replaced."

Monetary Policy vs. Political Risk

The divergence in bond yields highlights where investors are focusing their attention. Longer-dated debt is highly sensitive to political and fiscal risk, while shorter-dated notes are primarily driven by central bank policy.

With the Bank of England expected to hold interest rates steady on Thursday, the front end of the yield curve has been anchored. "While gilts are watching politics, the front-end will be paying attention to today's BOE meeting," said Jamie Searle, a strategist at Citigroup Inc.

Searle explained that with recent UK data surprising to the upside, there is little pressure on the Monetary Policy Committee to act. "Yesterday's rise in political uncertainty adds to the cheapening," he added, referring to the sell-off in longer-term gilts.

Market Anxiety Over a Post-Starmer UK

For investors, the instability is not just about a potential leadership change but what might follow. The market consensus is that any replacement for Starmer or his chancellor, Rachel Reeves, would be less committed to the UK's current fiscal rules.

"This is negative for the currency not simply because political instability is undesirable, but because any change in leadership is likely to be interpreted as fiscally expansionary," one analyst noted. "Given the UK's long-standing challenges around debt financing, markets will undoubtedly react negatively to such developments."

This sensitivity has been tested before. Just two weeks ago, gilts sold off after a potential path opened for Greater Manchester Mayor Andy Burnham, a left-wing rival of Starmer, to return to Parliament. Burnham, who has criticized the UK's deference to financial markets, is seen as a potential challenger for the premiership.

The political headwinds arrive at a difficult time for Starmer, whose Labour party is struggling with dire polling numbers and who faces a record disapproval rating himself ahead of local elections in May.