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U.K. Markets Escape Brexit Deadline to Face New Fiscal Risks

(Bloomberg) — Just as British politics looked to be quietening down for market traders, the finance minister’s surprise departure is leading to predictions of a spending bonanza.

That has investors preparing for U.K. government bonds to weaken relative to their peers, taking the shine off this year’s rally. Greater infrastructure investment aimed at boosting the economy may give the pound a temporary lift, yet longer-term sentiment is still shaky given tough talks over a trading relationship with the European Union still lie ahead.

Chancellor of the Exchequer Sajid Javid resigned Thursday after a row with Prime Minister Boris Johnson, with Rishi Sunak becoming the new chancellor. It’s no longer clear that the government will keep to fiscal rules that require its day-to-day spending and revenue to be balanced within three years.

“The market reaction of gilts selling off, a steeper rates curve and a stronger sterling clearly indicate that expectations are increasing for fiscal-stimulus announcements,” said Mohammed Kazmi, a portfolio manager at Union Bancaire Privee. “We could see a situation where U.K. gilts underperform German bunds further going into the budget.

Gilts bucked global bond gains on Thursday, sending 10-year yields to a three-week high. That narrowed their spread against U.S. Treasuries, where yields have been falling as the coronavirus sparks haven demand.

The pound rallied above $1.30 and sentiment in options markets has flipped in favor of further gains over the next month, but beyond that traders are still betting on weakness. As sterling gained, the FTSE 100 Index underperformed the region Thursday, given the benchmark’s predominance of global exporters.

The new finance minister, seen as a ally of Johnson, may give markets some comfort in a more united policy platform, said Nick Burchett, fund manager at Cavendish Asset Management. Sunak’s investment banking background should also be good for the City of London, he said.

However, the main risk for the U.K. financial sector continues to be the prospect of losing access to EU markets after the 2020 Brexit transition period. The EU and U.K. have been sparring over the ability of banks to operate in the bloc’s markets even before the talks have formally begun.

“The stance on the post-Brexit trade negotiations is a bit more muddled given that Javid was a big proponent of the equivalence, which may now be off the table,” said Valentin Marinov, head of G-10 currencies research at Credit Agricole (PA:CAGR) SA. “The big risk for the sterling bulls remains disappointment from the budget and the upcoming negotiations.”

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