The opinions expressed here are those of the author, the former head of communications at the Bank of England and a former senior editor at Reuters

By Mike Peacock

LONDON, May 7 (Reuters) - The bond market can be unkind to British prime ministers. The ruling Labour government - which could soon face a leadership challenge - will thus want to avoid upsetting investors at all costs. They might consider borrowing one tactic from U.S. President Donald Trump.

British Prime Minister Keir Starmer commands a significant parliamentary majority, but leads an increasingly fractious party that has blocked key policy plans, including cutting the welfare bill. Pressure has also mounted over his appointment of Peter Mandelson as U.S. ambassador, given Mandelson's links to the late sex offender Jeffrey Epstein.

Starmer’s future will be thrown into doubt again if Labour fares as badly as expected in a slew of regional elections on May 7.

If he goes, his replacement will have to win over Labour parliamentarians by tacking left, both to get elected as leader and to govern effectively. If Starmer survives, he will likely have to do the same.

Either way, markets will be wary.

UK 10-year gilt yields have soared around 70 basis points to 5% since the Iran war broke out, driven by the resulting energy shock. Britain has fared worse than most of its peers, reflecting its reliance on imported energy and concerns about inflation that was already stubbornly above target before the attack on Iran.

Whoever leads Labour will need to tread carefully. Memories are still fresh of the bond market meltdown that made Liz Truss Britain's shortest-serving prime minister in 2022.

Truss launched a programme of unfunded tax cuts while sidelining Britain’s independent economic institutions: the Bank of England (BoE) and the Office for Budget Responsibility (OBR). In turn, UK borrowing costs leapt by a full percentage point in a few days, and the BoE was forced to intervene and buy gilts.

The Labour government can seek to avoid this by, first, giving full-throated support to the OBR and BoE, reining in some MPs who have called for the OBR’s wings to be clipped.

But more will be needed. Any new attempt to increase borrowing and add to Britain’s debt pile is likely to go down badly. So how can Labour avoid a similar fate while pursuing an agenda that its left-leaning lawmakers will support?

TRUMP PLAYBOOK

One possible tactic comes from the current U.S. president.

While the main reason Trump's unorthodox policies have failed to scare away investors is that they cannot afford to shun the world’s largest economy, he has further anchored market confidence by appointing relatively orthodox figures to key economic policy positions, including Scott Bessent as treasury secretary and veteran central banker Kevin Warsh as his nominee to head the Federal Reserve.

Whoever leads Labour after May 7 should similarly aim to keep markets from overreacting by making sure to appoint a finance minister who signals a mainstream, responsible approach to fiscal policy.

So who might be right for the job?

THE CHANCELLOR QUESTION

Chancellor of the Exchequer Rachel Reeves has the economic credentials, but she is closely associated with the fumbling first two years of Starmer's government and multiple policy U-turns.

Her fiscal rules – intended to reduce debt as a proportion of gross domestic product within five years – have helped calm markets, something her allies are keen to point out.

The rules have done their job. The question is whether she still can. Anyone who succeeds her would have to adopt a similar regime.

A surprise pick could be Energy Secretary Ed Miliband, who led Labour in the opposition from 2010 to 2015.

True, he is routinely held up by critics as a symbol of everything wrong with a left-leaning government, and his zeal to shift to net-zero emissions has unsettled business, as it could push up their costs in the short term.

But his economic credentials are stronger than the naysayers acknowledge.

Before leading the party, he served as Chancellor Gordon Brown's economic adviser in opposition and then in government from 1994 to 2002 before heading the Treasury’s Council of Economic Advisers with a focus on long-term economic planning.

He has shown himself to be pragmatic. He accepted that fiscal consolidation was required after the global financial crisis – even though that went against his left-leaning tendencies.

As party leader, his 2012 policy of "predistribution" was mocked, but this strategy of developing a high-skilled, high-wage labour force as a route to cutting welfare payments and tackling cost-of-living pressures likely sounds less silly now.

Miliband’s spearheading of the drive to refit Britain’s economy for a net-zero world could also leave him well placed to deliver on the type of productive investment that the government has promised. Anaemic productivity growth is the root cause of the UK's dismal economic growth that has lasted for nearly two decades now.

Other potential candidates include junior Treasury minister Torsten Bell and veteran government minister Pat McFadden.

But Miliband offers the combination of economic expertise and frontline political experience. Moreover, his left-leaning reputation could actually give him the necessary credibility within his party to tackle tough issues, like the bloated welfare bill - a move that markets would certainly welcome.

Investor patience with the Labour government has worn thin. But the bond market has shown it can tolerate borrowing that is clearly aimed at growth-enhancing investment. The key is finding someone who can give the government a clear sense of direction – not a series of U-turns.

(The views expressed here are those of Mike Peacock, the former head of communications at the Bank of England and a former senior editor at Reuters.)

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