UK Elections Threaten to End the Pound’s Resilient Run

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(Bloomberg) — Investor worries over higher energy prices and elections that look to be disastrous for the government pushed the UK’s long-term borrowing costs to the highest level since 1998 this week. The pound wasn’t fazed.

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The currency has largely withstood the one-two punch from war and political uncertainty, turning in the third-best performance among Group-of-10 peers since March. Along the way, the pound has benefited from investor expectations that it will be a source of solid returns in a scenario where the Middle East conflict stokes inflation and the Bank of England is forced to hike interest rates.

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Now though, local elections have turned from abstract risk to immediate threat. If poor results for the governing Labour Party in Thursday’s vote suggest that Prime Minister Keir Starmer’s job is at risk, analysts expect the pound to feel some of the same pressure that’s rocked UK government bonds.

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“Gilts will be under pressure if Starmer is directly challenged,” said Neil Mehta, a portfolio manager at RBC BlueBay Asset Management. “Depending on the level and speed of the move in gilts, an already vulnerable pound will also likely sell off.”

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Gilts rallied Wednesday on speculation that the US and Iran are getting closer to a peace deal, but the yield on 30-year UK government bonds is still 0.6 percentage points higher than before the war. The pound is near its highest level versus the dollar since February.

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The currency has proven vulnerable to political upheaval, the most dramatic example coming in 2022 when former Prime Minister Liz Truss’ budget plan sparked a crisis that sent it below $1.04. Strategists at Wells Fargo & Co. and ING Groep NV said that while political risk has recently been overshadowed by rate expectations, the elections pose a risk to the pound.

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“There is currently no sign of any political risk premium in the pound,” said Francesco Pesole, FX strategist at ING. “This is somewhat surprising, given that a weak electoral result for Labour this week could raise the likelihood of PM Starmer’s exit.”

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Some 5,000 council seats are up for grabs in the elections, with voting also taking place for the Scottish Parliament and its Welsh equivalent, the Senedd. Political forecasters expect Labour to lose as many as 1,850 seats, with huge gains for Nigel Farage’s Reform UK and the Greens. There is a growing expectation in Westminster that Starmer could face a leadership challenge if the results are particularly bad. 

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What Bloomberg’s Strategists Say:

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“Thus far, the pound has been resilient in the face of potential looming political uncertainty with expectations of policy tightening from the BOE providing support. If a leadership challenge to Starmer is mounted and pressure on longer-dated gilts intensifies, the pound will likely struggle.”

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— Adam Linton, macro strategist. For the full analysis, click here.

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For investors, the risk is that Starmer is replaced by a prime minister who chooses to boost government spending to win back disaffected voters, adding further pressure the UK’s finances.