The Bond Market’s Specter Looms Over Labour’s Leadership Contest

The latest bout of political instability in Westminster has sent shivers down the spines of investors on the London markets, who are bracing for the possibility of another bond market meltdown. As Keir Starmer faces a potential leadership challenge, the City is warning that a repeat of Liz Truss’s disastrous premiership could be just around the corner.

The bond market’s concern is not just about ideology; it’s about fiscal discipline and coherence. Investors are wary of Labour’s leftward shift, which they believe will lead to higher levels of borrowing without a credible growth engine. The markets hate uncertainty, but they hate a political vacuum even more. A cabinet resignation followed by a leadership fight would signal that the government is losing control of itself while investors are already questioning the country’s fiscal direction.

Britain has elevated levels of borrowing and debt, with the national debt standing at almost 100% of GDP – the highest level since the 1960s. The cost of servicing this debt has risen significantly due to the rise in interest rates worldwide amid the inflation pressures unleashed after the Covid pandemic, the Russian invasion of Ukraine, and now the Iran war.

The implications are stark. Further borrowing on top of planned bond sales worth £252 billion to fund the government’s activities this year would risk driving gilt yields higher, adding to Britain’s already £100 billion-a-year debt interest bill – a sum representing about one-tenth of all public spending. This vicious spiral could drive borrowing costs even higher, creating an unsustainable situation.

The Labour leadership contest is being played out against this precarious backdrop. Some MPs are sanguine about the prospect of higher borrowing, while others are more pragmatic. Louise Haigh’s plan for the economy involves allowing higher levels of borrowing by overhauling the chancellor Rachel Reeves’s current fiscal rules. However, any changes would have to wait until after Labour has met Reeves’s main target of balancing day-to-day spending with tax receipts.

Analysts expect Labour to seek a balance between a “fresh start” and the avoidance of a Truss-style provocation – potentially involving the retention of Reeves as chancellor to benefit from her reputation with City investors. Jordan Rochester, an analyst at Mizuho, said: “I suspect the new leadership will attempt to calm down markets with a few words. But the party is shifting to the left and the market will price that in first.”

The bond market’s concerns are not just about Labour’s leadership contest; they’re about the country’s long-term economic prospects. Britain’s economy has been plagued by years of lacklustre growth, rising pressure to repair battered public services, and support an ageing population. The UK’s fiscal position is precarious, with a £100 billion-a-year debt interest bill that’s unsustainable in the long term.

As the Labour leadership contest heats up, the bond market will be watching closely. Any candidate vying for the top job must demonstrate a clear understanding of the country’s fiscal challenges and a commitment to fiscal discipline. The markets hate uncertainty, but they love a leader who can deliver a coherent economic strategy – one that balances ideological ambition with fiscal reality.

The stakes are high, not just for Labour, but for the entire country. A repeat of Liz Truss’s bond market meltdown would have far-reaching consequences, from higher borrowing costs to a reduced credit rating and increased debt servicing costs. The City is right to warn against such a scenario; it’s up to Labour’s leadership contenders to prove that they can navigate these treacherous waters with ease.

The question on everyone’s lips is: will Labour learn from the mistakes of its predecessors, or will it succumb to the same pressures that drove Truss out of office? Only time will tell. But one thing is certain – the bond market’s specter looms large over this leadership contest, and any candidate who fails to address its concerns will be doing so at their own peril.