Benstead on Bonds: should investors be worried about a Labour government?

As bond watchers were reminded in September 2022, when then-chancellor Kwasi Kwarteng’s “mini-budget” caused gilt yields to soar, politics often matters for bond prices.  

Whether it’s unfunded tax cuts or spending promises, or an austerity package, there will likely be a market reaction. This could be because borrowing is expected to soar, and the gilt market will have to absorb it, or the addition or withdrawal of stimulus will lead to a change in inflation and therefore Bank of England interest rates.  

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Labour is expected to win a majority in the UK general election on 4 July. A BBC collation of recent polling data gives Labour 44% of votes. The Conservatives are behind on 23%, while Reform UK has 13%. A YouGov poll gives Labour a majority of 194 seats, even more than its 1997 landslide victory.  

But how will bond markets react to a Labour victory? Given the party’s reputation for being more free-spending than the Conservatives, are investors worried about unfunded spending, and if so, are gilt yields set to rise as a result of falling bond prices?  

I think it’s helpful to take a step back and look at what normally drives bond markets.  

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James Lynch, investment manager at Aegon Asset Management, says that in normal circumstances the most dominant factors influencing the gilt market are the Bank of England policy rate and the data inputs into that decision, along with bond supply and the global financial market backdrop. 

This suggest that politics – at least not in the short term – is secondary to economics.  

Alexandra Ivanova, a fixed-income fund manager at Invesco, goes further, adding: “Investors need to break up gilt markets into three different parts: bonds maturing in the short, medium and longer term. 

“Shorter-maturity bonds are moving off the back of economic data, like services and wage inflation, as this impacts how the Bank of England acts.  

“The middle part of the curve is more driven by investment sentiment, and whether investors are feeling optimistic or not. 

“The longer maturity part of the gilt market is where assessments about politics and how government policy will shape the future.” 

Gilt yields have been moving on the back of economic data recently, rather than politics, but could that be about to change? 

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What would Labour mean for gilt yields? 

First, let’s consider that a Labour victory is assumed, as polling data shows. Therefore, what investors currently know and believe about a future Labour government is already in the price of gilts. But what is exactly in that price? 

Contrary to what some may expect, this Labour government is expected to be market friendly. Ivanova currently sees a Labour victory as “not negative”.  

She says that the party’s willingness to work closely with the European Union is a good thing, and if Labour wins a decisive victory then that would be good news as investors are looking for clarity. 

Lynch echoes this. The investor says that there are more positives for gilts than negatives if the polls are correct in pointing to a large Labour victory.  

He said: “First, an early election means there will be no final ‘giveaway’ budget from the government to win over last-minute voters. Second, the new Parliament with a large Labour majority will bring a sense of stability. Most likely five years of the same chancellor and prime minister should mean a coherent fiscal plan that is unlikely to be deviated from in short order.” 

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In fact, Lynch reckons that the experience of the Liz Truss government with the bond investors means that Labour is very focused on not upsetting markets.  

“Indeed, given the experience of 2022, the Labour Party is highlighting the importance of the Office for Budget Responsibility (OBR) and the Bank of England. If Labour wins, Keir Starmer will see a spending review first, followed by an autumn budget in October/November 2024.  

“The potential new government ‘gets it’ in terms of there being no quick fixes to a return to growth, and they know they cannot spend their way to growth via borrowing in the gilt market (in contrast to the Liz Truss government). At the margin, there will likely be an increase in tax take as extra investment will be needed in some public services.” 

In addition, Lynch says that a Labour government should also be helped by the improving macroeconomic backdrop.