All eyes on Number 10

Investors have spent much of this year fretting about events in the US and the Middle East. Now it is time for the UK to take centre stage.

Prime Minister Sir Keir Starmer is under mounting pressure. Leadership rivals are circling, including Greater Manchester mayor Andy Burnham. On Friday, Mr Burnham got the green light to stand as an MP, removing a key obstacle to a potential leadership challenge. Over the weekend, the contest heated up, with former health secretary Wes Streeting confirming that he would stand as Labour leader.

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This is making markets anxious. The cost of government borrowing is rising, with 10-year gilt yields above 5% - the highest they have been since 2008. Gilts are another name for government bonds. Meanwhile, 30-year gilt yields - which act as a benchmark for long-term UK borrowing costs - have climbed to their highest level since the 1990s.

The Middle East conflict is partly to blame for these market movements, but they also reflect fears of political change at home. Specifically, investors are worried that government spending will rise under a new Prime Minister, and that our self-imposed borrowing limits will be relaxed. This could widen the UK’s fiscal deficit (the gap between government spending and revenue), prompting investors to demand a higher risk premium to lend to the government.

We will learn more about the state of the UK economy on Wednesday, when the Office for National Statistics will publish inflation figures for April. UK inflation rose to 3.3% in March, but analysts think it will fall to about 3% in April due to the energy price cap. Things could kick into reverse, however, when the Middle East energy shock catches up with inflation data.

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Interest rate uncertainty

The pace of price rises will have a strong bearing on where interest rates go; persistently high inflation makes cuts less likely. Indeed, financial markets now expect the UK base rate to rise by the end of the year, and mortgage rates are already climbing.

The Middle East conflict is certainly stoking inflation elsewhere. The US - a net exporter of oil and gas - saw inflation jump to 3.8% in April due to surging petrol prices. That is the highest level in three years. Oil prices have risen again in recent days, with the international benchmark Brent crude currently at $110 a barrel.

This creates a tricky backdrop for Kevin Warsh, the new chair of the Federal Reserve, who begins his first full week in office today. The financier faces the unenviable task of juggling inflation, interest rates, central bank credibility, and pressure from President Donald Trump.

Mr Warsh arrives at the Federal Reserve with a more dovish stance on inflation. However, rate cuts could prove tricky given ongoing tensions in the Middle East, and markets are bracing for more unpredictability and dissent at the central bank.

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Stocks riding high

Despite the economic and political drama, the world’s biggest stock market is remarkably upbeat. The S&P 500 hit another all-time high last week, exceeding 7,500 points for the first time. Strong corporate earnings have played a major role, smashing expectations, and enthusiasm around artificial intelligence remains the big story.

This week brings key news in the sector: Nvidia’s quarterly earnings. Investors will scrutinise these for any signs of weakness in the AI mega-trend.

The European market is less buoyant. The FTSE 100 was steady this morning, but European stocks were slightly down. Both the UK and Europe are now trailing the US on a year-to-date basis, following the S&P 500’s impressive rebound in March and April. Europe’s reliance on fossil fuel imports is a particular concern.

Perspective is important, however. Despite all the geopolitical uncertainty, both markets have risen since the start of the year. The next few days will give a better sense of whether this can continue.

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