New UK prime minister, same bond market

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0:31Pushkin.

1:00From my home in Brooklyn, New York, joining me today is the incomparable and irreplaceable Ian Smith, all the way from London. Ian, what is it you do for us again? What's your job? I'm the senior markets correspondent, Rob, here in London. I am going to be the surrogate American listener today and pretend to be even more ignorant than I am about what's going on over there in markets and in politics. So let me start with a broad question. You have a new prime minister in waiting. He is some kind of pinko communist, if you believe what you read in the American press. And yet the gilts market, which is supposed to be the thing that keeps the pinko communists over there in line, is going up or at worst is indifferent to the whole thing.

1:56What is going on? Maybe you can start by just giving us a thumbnail sketch of who this person is. So Andy Burnham is the mayor of Greater Manchester. He's just won the Maker Fiat by-election, which has given him a seat at Westminster and means he is likely to become our next prime minister in a string of prime ministers in recent years. It's a brave new era in British politics. It's a lock though, right? it's going to be him. There's no chance somebody sweeps in at the last minute here. It's going to be him. It's going to be him. It's a lock. He's a really interesting figure, a senior Labour figure for some years, you know, figurehead on the left of the party, a champion of devolution, moving more power away from London and to other areas of the UK.

2:41He gave a big speech this week on moving some of the power in the UK away from Westminster. So it's a really interesting time that he's taking over. But he obviously inherits a lot of the challenges that Sir Keir Starmer, who will be leaving as the UK Prime Minister, faced, such as the UK's high debt, its sluggish growth, its unstable politics. So it's not going to be easy for him. No, but the guilts market, at least looked at naively, glancing at the chart of the 10-year guilt yield doesn't seem to be that worried on his behalf, that it doesn't seem to be signaling that he's a fiscally irresponsible person, or, you know, he'll reignite inflation, and so on.

3:29What do you what do you make of what guilt are doing right now? So it's interesting. Yeah, as you say, he's much caricatured by investors, Andy Burnham, I spoke to investors when he was, you know, coming to the fore and there was a lot of leadership speculation around Starmer. He was viewed among the leading candidates as the most market negative of them. There's a perception among gilt investors that he will look to borrow more and he will shift the party and the government to the left. And yet when it became very clear that he was going to become the next UK prime minister, the market reaction has been very calm.

4:03Sterling has been very stable. Gilt yields actually took down, which means prices rose on the day that he won the Maker Fiat by-election. So the reaction has been very calm from investors. I think there's a few reasons, some of which have nothing to do with the UK, which is the inflation threats to the global economy and to the UK, are lessening with the Iran war to some degree abating. But some of them are about the things that he has said and the face that he has presented to investors. And he sought to present himself as more of a centrist figure. Let's start with the war. It was striking to me that in the war's inflation scare, which was a global event where it looked like we weren't oil prices were going to go bananas.

4:47There was going to be second order effects on prices all over the world. We actually started to see that in some places. Yields everywhere went up. Government bond yields everywhere went up, meaning government bonds prices went down. but it was the UK that turned out to be the most sensitive. In other words, yields on the 10-year gilt moved up faster than those of other big developed countries, especially those in Europe. How do we explain that sensitivity? It's partly because the UK came into this conflict with inflation running higher than elsewhere. It was about 3 % in the UK, so it was higher than it was in the euro area.

5:28So that burst in inflation from the war fueled inflation that was already starting at a higher base. It also meant that there was a particularly sharp movement in interest rate expectations in the UK where people coming into the conflict thought there might be a couple of quarter point cuts at the Bank of England interest rate. And in quite short order, they moved to expecting increases to the interest rate. So there was quite a sharp shift in that because of the rising inflation expectations. That's partly because we have a lot of gas boilers. I have one and other reasons why we weren't sensitive to an energy shock coming from the Middle East.

6:04So, you know, our particular inflation sensitivities, which are one reason why we have the highest borrowing costs in the G7 already. We started from this higher base on inflation and interest rates, and this war really made that worse. So, yes, UK, France, Italy, you saw the bonds trade together in the early weeks of the conflict, but the UK was particularly hard hit. And there were also some hedge fund trades in the UK, people that had been expecting B of E rate cuts that you saw got kind of turned around. And that seemed to exacerbate some of the moves at the start of the conflict. It feels like the UK is just somehow, even putting aside the energy question, the UK is just more exposed to the winds of the global economy than many countries.

6:50In other words, the world gets kind of 2 % inflation, the UK always seems to get 3%. Or there's a global economic slowdown or acceleration, and the UK seems to accelerate or slow down more. Is that because it's kind of a trading – I mean, maybe I'm exaggerating this, but it's a trading nation, it has connections to Europe, etc., etc. Do you think the phenomenon I'm pointing to is real? Yes, it's real. And also, you know, we tore up our relationship with our biggest trading partner, right? So we have had sticky inflation since Brexit, which has made all of these things worse. We've also had elevated borrowing.

7:32So that's fed into some of our high borrowing costs that we have, which has created a bit of a negative feedback loop in our politics where, you know, there's not a lot of room for manoeuvre for centrist politicians. They try and keep the bond market creescent and, you know, not rock the boat. But that also means they're constrained in what they can do and their spending priorities. That's fed some of their unpopularity. And you've seen the rise of the populist parties on each side of UK politics. That's something that happens in a lot of different countries that we see at the moment. But the UK, obviously, we do have that mix of unstable politics, sticky inflation, fairly high guilt situance.

8:11And what we don't have, like the US has, is the world's reserve assets. So people don't have to buy gilts in the way that they used to. Exactly. And we've got a currency that can be targeted by international investors when there are worries about UK fiscal. So you can see us getting beaten up, but part of it just comes back to inflation. But what's been interesting is, as the conflict has gone on, and now with a peace deal and hopes that the inflation shock won't be as bad as expected, you've seen some of the interest rate expectations fall back you've also seen some softer economic data in the uk including inflation running lower than expected and that sparked a bit of a rallying in the run-up to this uh election of burnham at the makerfield by election so actually the backdrop is not so bad for him now it was would have been terrible at the start of this conflict but now we've had you know a couple of months of guilt prices rising and yields tightening and that has made some of these fiscal questions seem a little bit less drastic than they might have done.

9:12Yeah, he has a little bit of space. I want to turn the discussion to the future now. But rather than starting with Burnham, let's start with the Bank of England and what they're going to do about rate policy, because Burnham, of course, is going to have to respond to that. So where is the BOE now and where are they headed? So I think this is the big question and it is actually a bigger question for the gilt market than who does Andy Burnham pick to be his chancellor. I think it depends on your time frame there. But the real proximate question for gilts is what does the Bank of England do? Will it get away with not having to increase interest rates at all during this like rise in inflation that we've seen linked to the Iran war?

9:57Now, traders are expecting now maybe one quarter point rise to the BOE rate from the current 3.75 % by February. And they had been expecting a couple of quarter point rises by the end of the year. So you can see that it might be that the Bank of England doesn't have to follow the European Central Bank and actually increase interest rates. So some of the economic data on coming over the coming months is going to be really interesting to see whether the bank, because the UK economy actually isn't in the best spot right now, might not have to increase interest rates, might have to keep them lower to support the economy.

10:30And that might help keep gilt yields anchored versus other major bond markets and provide a bit of a better backdrop to some of the political risks that we'll see. There's the Bank of England. What about Burnham himself? What do you expect from him in the weeks to come? I thought it was interesting you commented he's been quite good at calming markets with the stuff that he's saying. Do you expect that to continue? Are there big speeches coming up we should have an ear out for? What are the kind of next steps with his premiership? So some of the things that Burnham has said in the past, he's talked last year about not wanting to be in-hawk to bond markets, comments which triggered much criticism from investors, obviously, and some hilarity in other quarters.

11:14he's also talked you know in recent months about taking some of an uplift in defence spending outside of the UK's fiscal rules so these are the self-imposed borrowing limits that we have you know trying to get debt as a share of GDP falling by the end of the parliament so from saying those things which are really the reason that investors were seizing upon them and saying perhaps he is more of a market negative a candidate that would shift labour to the left and lead to more borrowing he has now said i stick very much to the fiscal rules as they are currently written his team have walked back those comments he made around defense spending and he gave a big speech this week where he was very keen to emphasize his fiscal discipline and also talked about bearing down on areas like welfare spending so a lot of investors responded to that speech quite positively saying that he's showing some acceptance of the constraints on the UK.

12:07I suppose so the big questions are, who does he pick as Chancellor? Are they going to be someone that is more continuity of Rachel Reeves, who's been in recent months, at least very much kind of a friend of bond investors in terms of trying to hold to the fiscal consolidation that she has been pursuing? Also, what will Andy Burnham actually do? He has now said a couple of different things about what he'd like to do with UK borrowing. He also has big spending plans. So there really is a suspicion among investors that he will seek to loosen the purse strings to some degree, you know, and maybe he'll be emboldened by this stable reaction in the market that we've talked about to his premiership becoming very real.

12:48You know, one investor put it to me, said that there could be a kind of game of chicken now between Burnham and the bond market, where he might want to test just how far there is some acceptance of him pushing the needle on spending. Yeah, this was what was alarming about that. I don't want to be in hock to the bond market. One of the terrible facts, not just about the UK, but about life in general, is that we are all in hock at all times to the bond market. It's just, it's not up to us, as we all find out at one time or another. And to a certain extent, whatever tune the bond market plays, that's the tune we have to dance to.

13:32But I like, at the same time, your analogy of a game of chicken. The market is giving Burnham a bit of rope. Will he take it? And I suppose if you interpret him as saying, I don't want the bond market to be the kind of driving force in political decisions, political leaders have to lead. We have seen some of the problems that fiscal rules have created in terms of our economic policy, where you've seen the current government try and rebuild the buffer that they have against their borrowing limits by doing things that actually feed inflation or are unpopular. You know, so you have this kind of doing economic policy to kind of keep within these rigid tram lines in a way that maybe makes the government more unpopular and less stable.

14:14so him saying I want to kind of take back the initiative and lead and this is how I want to do it investors as you know can respond well to that if he does actually foster growth growth is a great way to get yourself out of a debt squeeze so if he can convince people that he can lift UK out of this growth funk then he will be able to improve the UK's debt dynamics and he will take some of the sting out of this criticism but the question is how does he do that he obviously wants to lift as he said growth in every postcode and put hope in every heart around the country but he has to deliver that growth and like what are the measures he'll take to do that how fiscally expansionary will it be those are unanswered questions that obviously will matter a lot to the bond market as much as they matter to the UK economy what you say reminds me a lot of and here I will date myself the United States in the early 90s where early in his presidency Bill Clinton famously moaned to his cabinet.

15:14So what you're telling me is my success or failure as president depends on what the bond market does. They basically said, yes, Mr. President, that's basically it. But what happened was he got this great burst of growth that solved all these problems, brought the budget deficit under control, calmed markets, and it was just like he was a blessed figure. I guess what I'm saying is there's only so much a national leader can do to determine the ultimate question here, which is growth. Growth is the thing that ultimately gets you out of trouble. What I'm reminded of in this circumstance is what John Madden said.

15:53He said, winning is the ultimate deodorant, which means whatever team, whatever problems your team has, who's arguing with who, this person hates that person. You can't work out this problem. If the team can just win, a lot of these problems or bad smells go away. Similarly, for governments, growth is the ultimate deodorant. Much is forgiven if the economy can grow a little bit. Certainly, and then it's quite interesting. He might then benefit, he would then benefit from some of the fiscal consolidation that's happened under this quite unpopular duo of our current Prime Minister, Sir Keir Starmer, and our Chancellor, Rachel Reeves, where if he managed to continue with the fiscal consolidation and guilt issuance is expected to kind of come down a bit this year and he manages to get a bit of growth going, then, you know, he can take benefit.

16:43Then he can take some credit for some of the decisions made in the past, carry the good ones through, and also leave things looking a lot better off. But yeah, like you say, whenever politicians take credit for interest rates, you think there are so many things that are outside of your control, the impact whether there are a kind of interest rate rises or cuts. Like, how can a politician take credit for that? You mentioned how unpopular the current prime minister and his administration is. And I want to end with a very broad question, which you may or may not be able to answer, but we can kind of feel around it.

17:18Is the UK ungovernable? Is this succession of unpopular prime ministers symptoms of something structural that none of them can fix. The reason I think this is important is because I see in what the UK is doing now a kind of glimpse of the American future, right? We haven't run up because of the position of our currencies, as you mentioned, and other special advantages the US has. We haven't gotten into the stage of persistent, repetitive fiscal crises that you just mentioned, but it seems like we're headed for that. is the UK in a structurally difficult situation? It just can't get out of no matter who the prime minister is.

18:00Just imagine the US if no one had to buy US treasuries, what the situation would be and how it would all play out in that environment. Yeah, no, I think that's... I'll tell you how it would play. There would be flames billowing from the windows of buildings. People would be running around in the streets with pitchforks and it would be an unbelievable nightmare. I care to contemplate it no longer. Go on about the UK. Yeah, I mean, I think it's a really good question. I think it's a bit simplistic to say that the UK is ungovernable. I think there are certain dynamics that are going to remain the same regardless of who's in number 10.

18:39You know, there are reasons why UK bond yields are high, inflation, a structural drop in demand from pension fund buyers and other dynamics that are shared. I think leadership does still matter. I still think you can design policies and inspire people. But I do think what we have, the way I put it, is not ungovernable, but that we have this bad feedback loop in our politics between sometimes a fragile bond market and some of the debt dynamics that we've discussed on this podcast and also our politics. And some people say, is the UK more like Italy in times past? A succession of leaders failing to deal with the same kind of debt problem and like the rise of populists.

19:19And that takes time to wash through. But I do think that political leaders can change things. Maybe I'm a hopeless, maybe I'm a hopeless, I can't even say it. You can't. I know, let me do it one more time. No, no, I'm not going to let that happen. You're trying to be optimistic and you can't do it because you're British. I can't bring myself to be optimistic without swallowing. That's my innate Britishness, I'm afraid. All right. There you go. That's as much as you get. Ian is trying to be optimistic. Let the record reflect. And we'll be right back with more optimistic or possibly pessimistic thoughts when we do long and short after the break.

20:06to every story. With the Flipside podcast from Barclays Investment Bank, you'll hear two research analysts having a provocative debate on hot topics in business and markets. Listen to the Flipside on your favorite platform. Listeners, welcome back. This is long and short, or is it long or short? I can never remember. In any case, it's that part of the show where we go long things we like and short things we don't like. And let me start, Ian, with a topic that I know is close to your heart. I am long every stock that is not a tech stock. The Magnificent Seven is the Magnificent Seven now, and semiconductor stocks are going sideways.

20:48We really need the rest of the market to take up the slack here. So I'm going long more in hope than in certainty. You are calling the great rotation. It doesn't happen until Rob says it is happening. What are you long at short, Ian? I am long the Portugal national football team, as I've just been given them in the office sweepstake for the World Cup. So I'll be hoping that Cristiano Ronaldo can finish his career with some glittering success on the world stage. On behalf of middle-aged men everywhere, I hope you're right about Cristiano and the rest of the team. Listeners, we will be back in your ears on Thursday.

21:27Until then, stay cool.

21:37We'll see you next time.