British Prime Minister Keir Starmer is resisting mounting calls for his resignation, but an analyst warns that the influential bond market will remain under a Damocles' sword until a clear successor is identified.

Starmer faces increasing pressure over his 2024 decision to appoint Peter Mandelson as ambassador to the United States, despite Mandelson's association with the disgraced financier and sex offender Jeffrey Epstein. The release of millions of new emails and documents related to Epstein has refocused attention on Mandelson's ties to the financier, who died in prison in 2019.

On Monday, government borrowing costs surged sharply as key members of Starmer's team resigned and a senior politician from his own Labour Party called for him to step down. By Tuesday morning, after supporters rallied around Starmer, the benchmark 10-year UK gilt yield had fallen to 4.509%, while the 30-year gilt yield declined to 5.319%.

Market observers indicate that a leadership challenge capable of disrupting the policy path set by Starmer and his Chancellor, Rachel Reeves, poses a significant risk to UK gilt investors. Should Starmer resign or a challenger gain sufficient support, it could trigger a leadership contest potentially lasting weeks.

Jordan Rochester, Head of FICC Strategy at Mizuho EMEA, stated in a Monday report that if a leadership contest is triggered, UK gilts might be "at the mercy of random political headlines" as the search for a new leader drags on. "We may see no movement from Starmer this week, and by next week we'll be back to trading CPI and PMI data as usual," Rochester said in the report. "But for many in the market, it's ultimately only a matter of time, as local elections could see Starmer's Labour party falter in the polls. Until the question of 'who's next?' is definitively answered, it's a Damocles' sword hanging over UK gilt traders." Local council elections are scheduled across various parts of the UK later this year.

Peel Hunt Chief Economist Kallum Pickering noted on Tuesday that the bond market would prefer Starmer and Reeves to remain in their positions. "Timing matters in politics – the Labour party seems both confused and fearful of the bond market," he said, referring to the ruling party. "What the government doesn't understand, but the market does, is that for fiscal policy, the issue for a developed, wealthy country like the UK is not debt or the deficit, but inflation. The UK is an outlier on inflation. That is why we pay a premium in the bond market. It is not an outlier on debt or the deficit." He suggested the bond market's "big headache" would ease when inflation potentially cools in the coming months.

"I think Starmer will be somewhat surprised by how much bond yields fall," Pickering noted. "The Labour party will be too, and they will say, in effect, this is a fairly safe prime minister now – so I think he will get through this."

Charlie Lloyd, Investment Director at Shackleton Advisers, said on Tuesday that a leadership contest would "almost certainly" cause short-term volatility in the UK bond market and increase borrowing costs via higher yields. "A protracted contest could impact the economy if UK gilt yields remain elevated compared to other bond markets for an extended period, not to mention the potential effect on consumer confidence."

Previously, the bond market has shown support for Reeves's self-imposed fiscal rules, which mandate that day-to-day government spending must be funded by tax revenues, not borrowing, and that public debt must fall as a proportion of economic output by 2029-30. When Reeves's political future was questioned last summer, UK gilt yields spiked 22 basis points in a single day, with market observers noting investor concern that her departure could lead to increased government spending and borrowing.

Potential successors to Starmer include the left-leaning Angela Rayner (who resigned as deputy prime minister last autumn over a tax scandal), Health Secretary Wes Streeting, and former Labour leader Ed Miliband. Lloyd stated that much of the unease in the UK gilt market stems from concerns that potential successors, such as Rayner and Manchester Mayor Andy Burnham, could be more politically left-leaning than Starmer.

If a successor takes office before June, they would become the UK's sixth prime minister in a decade. In 2022, then-Prime Minister Liz Truss announced a series of unfunded tax cuts that shook the UK gilt market, forced the Bank of England to intervene, and led to Truss resigning after just 44 days in office.

The UK has the highest long-term borrowing costs among the G7 nations. Among 20-year and 30-year bonds from these countries, only UK gilts have yields exceeding 5%.