(Bloomberg) — UK government bonds tumbled after Manchester Mayor Andy Burnham secured a pathway to potentially challenge Keir Starmer as prime minister, threatening political instability that investors fear could result in more expansive fiscal policy.

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The yield on 30-year gilts, the most sensitive maturity to political risk, surged as much as 20 basis points to 5.86%, the highest since 1998. Concerns about high energy costs and inflation also contributed to the move. Burnham’s announcement that he intends to run for Parliament — a prerequisite to challenge Starmer — put the pound on track for its worst week since 2024 against the dollar.

While there are plenty of hurdles on the path to 10 Downing Street, the prospect of Burnham becoming prime minister is seen as a risk by traders, who fear he might increase public spending and gilt issuance.

Although Burnham said that his remarks last year about the country being “in hock” to bond markets were taken out of context, they nonetheless spooked investors. He’s suggested there could be an exception for defense spending that would sidestep the government’s fiscal rules.

“The market’s fear is that Burnham would be more left-leaning, and we could see a further increase in deficits,” said Mohit Kumar, a strategist at Jefferies. “Our base case is one of a managed exit for Starmer and Burnham likely becoming the next PM. We keep our steepening bias on the curve and an underweight for the currency.”

The UK’s national debt has swelled sharply since the pandemic and is now at its highest relative to the size of the economy since the 1960s.

A sweeping defeat for Starmer’s Labour Party to populists Reform UK in local elections last week deepened concerns about his unpopularity with voters. Starmer and his Chancellor of the Exchequer Rachel Reeves are viewed by bond investors as more committed to keeping borrowing in check than their potential replacements.

Markets are particularly sensitive to the government’s debt sales after former Prime Minister Liz Truss’s unfunded spending plans sparked an exodus from gilts in 2022.

Global Challenges

The latest political uncertainty comes against a challenging backdrop as bonds fell globally on Friday amid concern about surging energy prices due to the Middle East war. The yield on 10-year gilts jumped as much as 19 basis points to 5.18%, the highest since 2008.

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Benchmark UK yields have risen by almost a percentage point since the US and Israel’s attacks on Iran, while traders have flipped pricing for Bank of England monetary policy from interest-rate cuts to hikes as inflationary fears mount.

Investors suggested gilts will need to fall further before they’ll buy in. Thirty-year yields rising above 6% would look attractive, according to Lauren van Biljon, senior portfolio manager at Allspring Global Investments, and Paul Skinner, investment director at Wellington Management. Lloyd Harris, head of fixed income at Premier Miton, said 10-year yields at 5.30% would start to appeal.

The pound was 0.5% lower against the dollar at 1.3331 and 0.2% down against the euro at 0.8725 at 5:40 p.m. in London.

Protracted Contest

Burnham’s announcement raises the stakes: The Manchester mayor is the only senior UK politician to hold a net positive approval rating among voters, according to YouGov, and is the preferred candidate for many on the left of the Labour Party.

Late Friday afternoon, a Labour spokesperson said the party’s National Executive Committee had granted Burnham permission to put himself forward as a candidate for an upcoming special election. It’s a reversal of policy since January, when he was denied the chance to run for a separate seat.

A potential leadership contest could be protracted, with Burnham first having to succeed in a by-election that Nigel Farage’s Reform has vowed to win.

While they have yet to formally announce a bid, other possible contenders include former Deputy Prime Minister Angela Rayner and Wes Streeting, who slammed Starmer’s administration in his letter resigning from the post of health secretary this week.

What Bloomberg Economists Say…

“Burnham has put forward more eye-catching proposals on tax and spending that could put the public finances at greater risk. These include halving the basic rate of income tax and increasing borrowing to fund defense spending. Still, it remains unclear how the constraints of office might temper his ambitions.”

— Ana Andrade, an economist covering the UK and the euro area for Bloomberg Economics in London

Burnham’s various comments regarding fiscal policy over the last year have attracted market attention.

Following his “in hock” remarks, he said in April that Labour’s budget constraints “will stay in any context,” while suggesting there could be an exception for defense spending. His argument, he says, is not that Britain can ignore markets, but that tax-and-spending decisions shouldn’t be whipsawed by short-term factors.

“The gilt market reaction is to be expected, but once again the gilt market is scared of its own shadow,” said Craig Inches, head of rates and cash at Royal London Asset Management Ltd.

“Burnham will need to be very gilt market friendly in his comments otherwise the UK headroom will have disappeared before he gets to No. 10.”

–With assistance from Naomi Tajitsu, Georgia Hall, Alice Atkins and Greg Ritchie.

(Updates prices and adds Labour’s decision on Burnham in paragraph 15.)

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