(Bloomberg) — Investor worries over higher energy prices and elections that look to be disastrous for the government pushed the UK\u2019s long-term borrowing costs to the highest level since 1998 this week. The pound wasn\u2019t fazed.<\/p>\n
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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.<\/p>\n
Now though, local elections have turned from abstract risk to immediate threat. If poor results for the governing Labour Party in Thursday\u2019s vote suggest that Prime Minister Keir Starmer\u2019s job is at risk, analysts expect the pound to feel some of the same pressure that\u2019s rocked UK government bonds.<\/p>\n
\u201cGilts will be under pressure if Starmer is directly challenged,\u201d said Neil Mehta, a portfolio manager at RBC BlueBay Asset Management. \u201cDepending on the level and speed of the move in gilts, an already vulnerable pound will also likely sell off.\u201d<\/p>\n
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.<\/p>\n
The currency has proven vulnerable to political upheaval, the most dramatic example coming in 2022 when former Prime Minister Liz Truss\u2019 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.<\/p>\n
\u201cThere is currently no sign of any political risk premium in the pound,\u201d said Francesco Pesole, FX strategist at ING. \u201cThis is somewhat surprising, given that a weak electoral result for Labour this week could raise the likelihood of PM Starmer\u2019s exit.\u201d<\/p>\n
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\u2019s 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.<\/p>\n
Story continues <\/p>\n
What Bloomberg\u2019s Strategists Say:<\/p>\n
\u201cThus 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.\u201d<\/p>\n
\u2014 Adam Linton, macro strategist. For the full analysis, click here.<\/p>\n
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\u2019s finances.<\/p>\n
\u201cThere is greater scope for politics to be more influential, and the risk of curve steepening to increase, should the election results come out weak for Labour,\u201d said Marcus Jennings, strategist at Wells Fargo in London. Such an outcome would also add pressure to the pound, pushing it toward 0.89 per euro later in the year from around 0.863 now, he added.<\/p>\n
Some investors have been trimming their exposure to the UK. In the past two weeks, Ales Koutny, who manages actively traded funds at Vanguard Asset Management, exited his long-held position to sell the euro against the pound, wary of \u201cpolitical noise\u201d following the vote.<\/p>\n
\u201cIf there is talk about resignations, this could be the trigger of more political risk in the UK which keeps investors on their toes,\u201d said Koutny. \u201cBut we\u2019ve have bouts of this before, and then it fades away.\u201d<\/p>\n
Sunil Krishnan, head of multi-asset at Aviva Investors, is positioned for the pound to fall versus the euro. While both the UK and the euro area are exposed to the energy shock, the UK has less room to increase fiscal expansion than a country like Germany, he said.<\/p>\n
Much depends on timing. Bloomberg reported over the weekend that Starmer\u2019s rivals for the top job think a \u201cperfect storm\u201d of events is needed to bring him down.<\/p>\n
\u201cThere\u2019ll be pressure on Starmer, there\u2019ll be chatter about what could happen next,\u201d said Nomura strategist Dominic Bunning, who is positioned for the pound to weaken against the euro but expects the story to play out over time.<\/p>\n
\u201cIt may well be that you just have to wait another three or four months before you really start to see the knives coming out,\u201d he added.<\/p>\n
–With assistance from Sujata Rao.<\/p>\n
Most Read from Bloomberg Businessweek<\/p>\n
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