How will UK government bonds react to a change of government in the UK?

• Bond investors have largely ignored the Tories and Labor election manifestos
• Tax rules and the memory of the Liz Truss market collapse are keeping promises in check
• But investors are cautious about ‘deterioration of discipline’ and the need for tax increases

Official opinion polls suggest Britain is on course for a change of government next week after 14 years of Conservative Party rule, with the new leadership tasked with pulling the economy out of the doldrums.

Labour looks set to secure a historic victory, with Keir Starmer’s party pledging to deliver the highest sustained economic growth in the G7 “with good jobs and productivity growth” while transforming Britain into a “clean energy superpower”.

But whoever wins on July 4 will do so in the shadow of Liz Truss’s disastrous 2022 mini-Budget, and the devastation the unfunded tax cuts have wreaked on the country’s finances – and on the personal finances of its citizens too.

How will debt markets react to a change in government and can Britain restore its economic prosperity without another market collapse?

Gilts in fashion

Private investors have been flocking to government bonds (government debt issued by the UK government) since the start of the year, attracted by solid yields and an expected rise in bond values ​​as interest rates start to fall later this year.

Hargreaves Lansdown said in April that first-quarter government bond purchases on its platform were three times higher than the same period last year, while Interactive Investor saw its best month for government bond sales in ten months.

Retail investors have been particularly interested in short-term government bonds – bonds that mature within a few years – where there is more clarity about the direction of interest rates and a shorter time horizon to recover the full value of their investment.

Demand for the bonds has increased as base rates have peaked and the first rate cuts from the Bank of England are on the horizon.

The price of a bond rises and falls inversely with its yield. The yield on two- and five-year government bonds has fallen by 91 and 52 basis points respectively in the past year.

With yields of 4.2 and 4 percent on two- and five-year bonds respectively, they are well below their post-Truss peaks.

Manifestos were met with a shrug

Unlike the Truss era, when moves in Westminster angered unionists, markets have been largely unaffected by the publication of party manifestos ahead of a general election.

Two- and five-year bond yields have fallen 27 and 16 basis points respectively over the past month, while longer-term yields have also fallen.

But analysts say this is driven by expectations of impending rate cuts, rather than in response to political promises.

Susannah Streeter, head of money and markets at Hargreaves Lansdown, said: ‘So far, the commitments and promises made do not appear to have disrupted debt markets, with 10- and 30-year UK government bond yields falling compared to the past. week, [and] Bond investors seem to be more sensitive to interest rate speculation than to the investment plans of a new government.’

Politicians, they are all the same!

But the lack of a markedly negative response to the election manifestos of both the Conservatives and Labor parties can be attributed at least in part to the reluctance of both parties to be generous with their respective promises.

The Conservative government and Labour’s shadow Chancellor of the Exchequer Rachel Reeves have both committed to so-called ‘fiscal rules’, which require the national debt as a percentage of GDP to fall over a five-year parliamentary term.

Due to the unstable and ever-growing debt mountain that our governments have built up over the past 30 years, we do not have the financial space for ‘out of the box’ policies

Fredrik Repton, senior portfolio manager at fund house Neuberger Berman, said both current Chancellor Jeremy Hunt and the BoE had done a “good job” of restoring investor confidence in Britain through tighter policy and effective market communications.

Both parties will do everything they can not to damage that trust.

Tom Becket, co-chief investment officer at Canaccord Genuity Wealth Management, said: “Because of the staggering and ever-increasing debt mountain that our governments have built up over the past 30 years, we don’t have the financial or fiscal leeway to go ‘out of the box’ -policy.

‘Fortunately, the Labour manifesto seems pretty stable. The ill-fated Liz Truss government was a stark reminder of the practicalities of policing our country in its shaky financial position.’

A ‘changed’ Labor Party and its crucial first budget

As part of efforts to demonstrate Labour’s renewed commitment to fiscal responsibility, Reeves has dropped a £28bn-a-year green investment plan that only months ago formed the basis of the Labor Party’s offer to the British public.

Nor have Reeves and Starmer made any attempt to hide their efforts to warm to the City, with Labour keen in the eyes of the markets to shake off its Corbynite recent past.

Neuberger Berman’s Repton told This is Money that debt markets currently don’t see any major difference between the two main British parties.

He said: ‘That’s why the markets are so optimistic about the election.

‘We manage bond funds, we are not political analysts. But when we look at this, we don’t see any material difference, at least at first glance.

“We expect the Labor Party will also be fairly conservative in the way it communicates with the markets.”

However, Repton warned: ‘There is always the risk that discipline will deteriorate somewhat over time’ and Labour’s first budget ‘will be very important’.

While both Labour and the Tories are keen to emphasise their own financial responsibility, they are also noticeably vague about their tax plans.

Both parties have ruled out increases in the state’s main sources of revenue – income tax, national insurance and VAT – while denying they will make increases elsewhere.

This is despite the fact that most economists agree that tax revenues will need to rise in the next parliament even to meet current spending and debt service responsibilities.

Repton said: ‘This is something that has to be addressed at some point, regardless of who wins the general election.’

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Does the color of the rosette matter at all?

Research from investment platform eToro shows that 44 percent of retail investors believe a Labor victory in the general election will be a bullish sign for UK stock markets, while 30 percent say the opposite.

Canaccord GWM’s Becket said international investors could “breathe a sigh of relief because of the change of political guard” after a period of stagnation in Britain.

However, analysis by fund giant Vanguard shows that the British stock market has hardly been affected by the elections in recent times.

Vanguard data shows that the seven general elections that took place between January 1995 and December 2023 had “minimal impact on stock market performance.”

It added: ‘The events that most affected the stock market were of a much larger, global scale.

‘These included the bursting of the dot-com bubble (when tech stocks fell after a rapid rise in valuations in the late 1990s), the global financial crisis in 2007-2009 and the Covid-19 pandemic in 2020.’

And longer-term analysis by Simon French, chief economist and head of research at Panmure Gordon, suggests the policy difference between Labour and the Tories is not as great as many voters might think.

French said: ‘The quarterly GDP data from Conservative and Labor led governments is virtually identical.

‘There is no historical evidence – at least not since reliable GDP data has been available – that Conservative or Labour governments are better or worse for UK economic growth.

There is no historical evidence – at least not since reliable GDP data has been available – that Conservative or Labour governments are better or worse for UK economic growth.

‘When we talk about fiscal policy, this is probably the finding that most contradicts the prevailing commentary/conventional wisdom. Since 1955, budget deficits under Labor governments have been modestly smaller (2.9 percent of GDP) compared to Conservative governments (3.3 percent of GDP).

‘Another aspect for capital market participants to consider is the strength of the pound under different governments.

‘On average, the long-term weakening of GBPUSD over the past 70 years has been stronger under Labor governments (-0.26 percent quarter-on-quarter) than under Conservative governments (-0.16 percent quarter-on-quarter).

“These are relatively small differences, however, and it is difficult to identify a pronounced difference in currency performance in an overall devaluation trend.”