The UK government has descended into severe political turmoil in recent weeks, leaving Prime Minister Keir Starmer fighting to save his premiership.
Claudio Wewel, FX strategist at J. Safra Sarasin Sustainable Asset Management, shares his insights.
The collapse of authority follows the Labour Party’s disastrous performance in the May 7 elections, combined with the political scandal surrounding the appointment of Peter Mandelson as US Ambassador, who was chosen for the position even as he reportedly failed his security vetting.
Since 2016, domestic politics have been a key driver of the pound
Over the past decade, domestic politics have turned into the perhaps most important driver of pound sterling, with several episodes of elevated economic uncertainty weighing on the currency. As the tenth anniversary of the Brexit vote approaches in June, the pound is about to conclude a turbulent decade. The prospect of a ‘no deal’ periodically weighed on the currency and largely accounts for elevated exchange rate volatility in the late 2010s.
The conclusion of a Brexit deal and the relatively successful rollout of the UK’s Covid vaccination scheme – with the UK government securing a vast amount of the very first Astra Zeneca vaccines available at that time – delivered a temporary boost to the pound in 2021. Yet the currency weakened again as the market refocused on the fiscal implications of the government’s extensive Covid relief packages.
The market reached peak pessimism after PM Liz Truss announced her unfunded ‘mini budget’ in late 2022, which saw GBPUSD approaching parity. Currency support increased under the leadership of PM Rishi Sunak, as tax increases and budget cuts restored investors’ confidence in UK government bonds.
Starmer will face a contest over his leadership
The current government crisis has the potential to inflict renewed pain on the pound. With the resignation of Health Secretary Wes Streeting from the Cabinet, the government crisis has anything but deepened further at the end of last week. Mr Streeting has confirmed that he will run in any future leadership contest, seeking to distinguish himself by reopening the Brexit debate and calling for the UK to eventually rejoin the EU to undo the ‘catastrophic mistake’.
Moreover, Andy Burnham, the highly popular mayor of Greater Manchester, is positioning himself to challenge Starmer for the leadership of the Labour Party. But to do so, Burnham will need to win the Makerfield by-election, scheduled for mid-June. This will be a challenging race, given the recent surge in support for opposition parties.
UK government bond yields are higher
It is not only the flip-flopping and the UK’s perceived lack of longer-term strategy that are causing unease among investors. For instance, parallels have been drawn to Italian politics, noting that the mean tenure of British prime ministers has shortened substantially since the GFC, raising alarms over fiscal sustainability in the UK, given the often-observed correlation between political instability and fiscal instability.
In essence, investors are increasingly worried that a more leftist or populist successor of PM Starmer would engage in reckless spending and worsen fiscal discipline, which has driven gilt yields higher, especially at the long end of the curve.
What also matters is that the foreign ownership of gilts has risen substantially in recent decades, leaving the gilt market much more exposed to the possibility of a sell-off, as foreign investors tend to react much more sensitively to political shifts than the domestic investor base, which usually proves to be stickier.
Not much of this is currently priced in the currency
Aside from small fractures, the pound has hardly reacted, so far, to the current political crisis. Recent currency moves have been contained by historic standards. Instead, the surge in political uncertainty has been reflected in a rise in option-implied volatilities and a build-up in net short positions. Similarly, risk reversals indicate that investors are bracing themselves for the possibility of more turbulence ahead.
Although there is no timetable for Mr Starmer’s departure at this point and he insists that he remains ‘focused on doing his job’, there is scope for the risk premium priced in the pound’s current spot exchange rate to widen from here. This implies that the pound will face more downside in case PM Starmer were to lose a potential leadership contest against Wes Streeting or Andy Burnham later this year.
