- Burnham faces twitchy bond market which could limit room for manoeuvre
- UK yields are highest in G7, country vulnerable to energy shocks
- Britain continuing to borrow heavily, but U.S.-Iran deal has soothed market
LONDON, July 7 (Reuters) - Britain's brittle bond market is looming large over Andy Burnham, Britain's likely next prime minister, and could constrain what the left-leaning former mayor of Manchester can do in office.
Burnham has already moved to calm investors’ nerves over a potential spending surge by promising to stick to the government's current fiscal rules.
Yet Prime Minister Keir Starmer has left him with a £4.7 billion ($6.27 billion) funding gap for defence, suggesting he use the government's "headroom" against the spending rules to plug it.
Burnham has had some good fortune, however. Britain's bond yields - and so government borrowing costs - have fallen sharply as a U.S.-Iran deal has caused oil prices to tumble.
Here are the key pressure points facing Burnham in the bond markets:
Yields on benchmark 10-year bonds are higher than in other rich economies and hit an 18-year peak in May as the Iran war drove up energy prices.
Britain has struggled to tamp down inflation in recent years, keeping interest rates high. High public debt, and the scars of the Liz Truss mini-budget crisis in 2022, have also been factors keeping yields elevated.
Yields dropped as bonds rallied in mid-May when Burnham committed to the fiscal rules, although the main driver was the developing U.S.-Iran peace agreement which pulled down borrowing costs globally.
Markets are keen to hear who Burnham's choice of finance minister, or chancellor, will be and whether he will ultimately bend the fiscal rules slightly.
"When the government returns in September ... that's when things really heat up," said Neil Mehta, portfolio manager at RBC BlueBay.
"That's when you start to hear rumours about policy changes and that's when the gilt markets become a bit more nervous."
Burnham will have to contend with a UK bond market and economy that's vulnerable to energy shocks.
Britain is an energy importer with low levels of storage and a gas-driven electricity pricing model, which has pushed up its bond yields more than others during the war.
Mustafa Oguz Caylan, G10 rates strategist at UBS, said longer-dated bonds are more sensitive to inflation in the UK than the U.S. and Europe.
"That partly has to do with the UK having very high inflation-linked debt, roughly 25%," he said. "The dislocation in the gilt market in 2022 is also another factor."
Debt interest spending was £3.3 billion above forecasts in May alone as inflation pushed up payments on inflation-linked bonds, according to the Office for Budget Responsibility.
The government borrowed hundreds of billions of pounds to support the economy through COVID-19, then was rapidly hit by the Ukraine war energy shock, keeping bond issuance high.
Meanwhile, the Bank of England is actively selling its pandemic-era bond holdings, adding to the pressure on markets to absorb the debt.
"The positive I see is that the level of gilt yields is so front and center of the political discussion," Kim Crawford, global rates portfolio manager at JP Morgan Asset Management, said at a conference last month.
"I think there is an understanding that budget constraints are tighter now."
It's not all gloom, however.
International factors are typically the biggest driver of UK bond markets, and the U.S.-Iran framework deal has let energy flow through the Strait of Hormuz and oil prices slide back to pre-war levels. That has prompted traders to sharply scale back their bets on central bank rate hikes.
"We are positive on the outlook for UK gilts," said James Bilson, a fixed income strategist at Schroders.
"In our view, most indicators point towards policy easing in the UK rather than tightening."
Yet many of the underlying fiscal problems that weighed on Starmer will remain.
Britain spends around 9% of its revenues on debt interest, which is forecast to be roughly £109 billion in 2026/27, compared to around £68 billion on the defence budget, highlighting the trade-offs Burnham will soon have to face.
($1 = 0.7495 pounds)
Reporting by Harry Robertson; Additional reporting by Naomi Rovnick; Editing by Amanda Cooper and Ros Russell
Source: Reuters