Gilts surged and the pound rose after Starmer defended Reeves, but fiscal doubts linger

A political firestorm rattled the City on Wednesday—then calmed just as swiftly—after Prime Minister Keir Starmer reaffirmed his full support for embattled Chancellor Rachel Reeves, sending bond markets into recovery mode.

The yield on 10-year UK government bonds, or gilts, plunged back toward 4.5% on Thursday morning, erasing much of the sharp spike triggered by speculation Reeves might be ousted. The pound also edged higher against major currencies. But beneath the rebound, markets remain uneasy.

The tremors began when Starmer appeared less than forceful in backing Reeves during Prime Minister’s Questions, fuelling rumours she might resign amid a bruising U-turn on the government’s controversial welfare bill. Hours later, a visibly emotional Reeves was defended publicly by Starmer during a BBC interview in which he pledged she would remain in post “for a very long time”.

The reassurance worked—momentarily.

City analysts interpreted Starmer’s move as an attempt to calm markets increasingly spooked by the government’s fiscal credibility. Reeves, long viewed as Labour’s anchor to economic orthodoxy, is considered “market-friendly” by investors who fear that any replacement might unleash a looser approach to borrowing and spending.

Neil Wilson, strategist at Saxo Bank, explained: “The calculation was that Reeves is probably the most market-friendly chancellor Labour could field, so replacing her indicated a higher chance of changing fiscal rules, implying more debt and instability.”

But the damage may already be done.

The government’s credibility took a blow this week when a £5.5bn cut to disability benefits was scrapped following a revolt by Labour backbenchers—just weeks after a £1.25bn U-turn on winter fuel payments for pensioners. Together, the two reversals have left a hole in the public finances that threatens to derail Reeves’ much-vaunted “iron-clad” fiscal rules.

Those rules commit the government to balancing day-to-day spending with revenues within five years. But with growth sluggish and debt interest payments rising, economists are warning that Reeves could miss her targets without further tax hikes or spending cuts in the autumn budget.

In short, Reeves is stuck: raise taxes further and face public backlash, or borrow more and face a bond market revolt.

“The market is getting nervous about Labour’s ability to make the sums add up, whether Reeves stays or not,” said Wilson. “The economic outlook is hardly improving.”

And storm clouds are gathering internationally, too. Fresh US job market data released Thursday suggested the Federal Reserve might delay rate cuts—pushing US bond yields higher and feeding global market jitters. Analysts warn that this could further constrain Reeves’ room to manoeuvre.

A glimmer of hope came from a sharp rise in UK services sector activity, according to the S&P Global PMI survey, which indicated improving consumer and business confidence. But economists caution this won’t be enough to fill the £9.9bn fiscal hole left in Reeves’ spring statement headroom.

Meanwhile, Deutsche Bank’s Jim Reid offered a stark choice: “Unless we get a big burst of growth before the budget, the government will need to announce further tax rises or spending cuts to meet the fiscal rules. It’s a tricky position.”

As Starmer tries to hold the line and Reeves clings on with his blessing, investors are watching closely. With a fraught autumn budget looming, many in the City are quietly bracing for another storm—one that even a tearful Chancellor and a loyal Prime Minister might not be able to weather.