The Labour party is approaching its first year in power and this week we’ve had a reminder of the potential for political uncertainty to influence the UK’s bond and currency markets.
Gilts yields spiked and the pound fell on July 2 when the chancellor, Rachel Reeves, was seen in parliament in tears, triggering speculation that she was about to resign or be replaced with someone less fiscally conservative. Markets then returned to previous levels on July 3 as the prime minister, Sir Keir Starmer, said that the chancellor would remain in her post “for years to come.”
This followed a period of political turbulence for the government as it failed to push through welfare reforms that would have eased some of the pressure on its finances. The independent Institute for Fiscal Studies, which regularly scrutinizes the government’s fiscal plans, said that the watered down reforms will cost the government £3 billion by 2029-30, against a potential saving of £5 billion.
Our bond market outlook recently noted that UK bond yields, which among other factors indicate market fears over political and economic risk, started Q3 lower than at the start of Q2.
Because yields move in the opposite direction to prices, a rise in yields can occur when investors sell a government’s debt, a vote of no confidence from markets. Falling yields show investors are buying debt.
UK Bonds: Summer Recess, Autumn Crisis?
The UK parliament goes into “summer recess” on July 22 and returns on September 1 so commentators argue that a change to the UK’s most senior economic role seems unlikely.
Some fund managers are less sure that this crisis will go away, however. Neil Mehta, portfolio manager at RBC BlueBay Asset Management, says that this week’s events “underscore the government’s waning control over public spending.”
“A fiscal crisis now appears to be on the horizon unless tough decisions (such as tax rises) are enacted. Markets will be on high alert over the next months.”
In determining prices and yields, UK bond markets reflect multiple factors including interest rates, inflation expectations and how effectively the government is managing public finances. The third of these factors became significant in September 2022, when a Budget toppled both the prime minister and chancellor and caused a short-term crisis in UK markets.
Since Labour assumed power, the chancellor’s “fiscal events” have not triggered UK bond market volatility. At the same time, longer-term bond yields are higher than when Labour assumed power on July 5, 2024, and this has a direct impact on government borrowing costs: the yields reflect what the UK state has to pay investors to buy sovereign debt.
Key Events for the UK Chancellor Since 2024
- Autumn Budget—Oct. 30, 2024.
- Spring Statement—March 26, 2025.
- Spending Review — June 11, 2025.
- Mansion House Speech — July 15.
- Autumn Budget 2025—Oct./Nov. 2025.
Bond Markets Await the Autumn Budget
March’s Spring Statement focused on the government’s “fiscal headroom,” the buffer it has to increase spending or cut taxes without breaking its own rules. On the day, chancellor reassured markets that this buffer would grow to nearly £10 billion by 2029-2030.
Chris Iggo, AXA IM’s chief investment officer for core investment, notes the challenges that lie ahead after the summer recess.
“The summer should be quiet, but markets will look toward the Autumn Statement and what new policies can be introduced to ensure the UK stays within its fiscal rules.”
He argues that this week’s gilt yield move will be a reminder of the power of bond markets to signal disquiet over political events.
“Higher bond yields are sobering for politicians and the government will be keen to restore confidence.”
Long-Term Yields Are Higher, Short-Term Yields Are Lower
At 4.72%, 10-year spot gilt yields are higher when Labour came to power in July 2025, and 30-year gilt yields are also higher, at 5.53%. Still, the yield increase among longer-dated yields has been a global trend, and reflects investors’ assumptions that governments will have to spend more to fund higher defense budgets and aging populations, . This increase also reflects expectations of higher inflation and rates in the next few decades.
But short-term UK yields are lower than a year ago, although this also reflects falling inflation and the four interest rate cuts since Labour took power.
Key Facts on the UK Economy and Politics
- Tariff impact: the UK has a preferential trade deal with the US.
- The government has a large “majority” in the House of Commons, in theory making it easier to pass laws.
- UK debt-to-GDP ratio is lower than the US, Japan.
- The next election is likely to be more than four years away, as late as August 2029.
- UK inflation is above target, and higher than in the eurozone and United States.
- At 4.25%, UK interest rates are more than double those in the eurozone.
- The UK stock market is about 10% higher than a year ago and has hit record highs.
- The pound is much stronger against the dollar over a year, mainly due to dollar weakness: a pound buys $1.37, from $1.27 last July.
- UK economic growth is weak, with a contraction in the economy in April.
ISA Savers Will Watch the Mansion House Speech Closely
This is a government which faces a precarious fiscal situation and cannot escape from that reality.
MUFG Europe economist Henry Cook
A year on, Labour seems to have burned through a fair amount of political capital already.
“Markets have taken the view that the government is politically unable to follow through on promises that is reduce welfare spending, ramp up defense spending and not increase income taxes,” Iggo says.
“Despite a huge majority in parliament, the Labour government appears to have lost any room for maneuver when it comes to fiscal policy. Markets sense that abandoning the fiscal rules—allowing the deficit to increase relative to the previous baseline—might become politically tempting.”
MUFG Europe economist Henry Cook agrees:
“Any hope that some stability under a government with a large majority and still four years to the next election would support activity now looks decidedly optimistic.
“The government has stated that it is focused on growth but, some planning reform aside, seems to shy away from any sort of politically difficult decisions which could boost activity further ahead.
“Ultimately this is a government which faces a precarious fiscal situation and cannot escape from that reality.”
Cook notes that Rachel Reeves’ next significant public appearance will be at the Mansion House in the City of London on July 15. This event will likely feature the government’s push for pensions to allocate more to private markets.
Investors and savers will be more focused on already leaked plans to cut cash savings allowances, which are expected to be announced then.
