Banks recover after AI scare trade, as UK Gilts get boost from PM

There are some key trends developing in financial markets this week, even though liquidity is thin due to the US Presidents Day holiday and the Lunar New Year, which means that Chinese markets are also closed.

European stock indices are a sea of green this morning, as financials lead the way higher. This comes after a nasty sell off in European banks last week, as the AI fear trade attacked the sector. The financial sector is higher by 1.5% on Monday in the UK, with NatWest, Barclays and Prudential leading the way. NatWest is higher by more than 4% today, after a bruising month when the stock has lost over 5%.

The UK is in focus today as US markets are closed and news elsewhere is fairly quiet. The main news from the Munich Security Conference is that the UK wants a closer relationship on trade and defence with the EU, and the UK may rush through its plans to boost defence spending. Aside from banks, there are also decent gains today for FTSE 100 defence names like BAE Systems.

The PM has also said that he will lead the Labour Party into next year’s election and has come out fighting against his rivals within the Labour party. UK Gilts are the top performers in Europe so far on Monday, and the 10-year Gilt yield is lower by 2bps. UK yields fell sharply last week as they followed US Treasuries. UK bonds also recovered as treats of a leadership challenge to the PM fell away. Over the past month, UK Gilts have been clear under performers globally, as political risks increased with the hard left pushing to oust the PM. The Gilt market’s recovery suggests that Starmer and Reeves are still considered the ‘safest’ pair of hands to deal with the economy in the Labour party.

The writing could still be on the wall for Starmer, as he has just reversed his decision to delay 30 local elections in May. Early polling suggests that Labour is set to face a challenging set of local elections in May, and today’s U-turn could make that worse for the party. Labour is expected to see widespread losses including the loss of control of 6 major councils including Blackburn, Exeter and Preston.

Bad results are also expected in Scotland and Wales, and even London, usually a Labour strong hold, could see seats lost to rival parties. These elections are seen as a referendum on Labour’s time in office and their policies so far. Thus, if Labour get the drubbing that is expected we predict two outcomes: firstly, speculation around Starmer’s leadership could heat up once more, adding to pressure on Gilts and also the pound, which has been the weakest currency in the G10 FX space so far in February.

The second scenario, is that the wider Labour party see these election results as a chance to change direction, and potentially to take a more pro-growth stance that could boost economic growth, without upsetting  the bond markets, for example focusing on tax breaks and benefit cuts, and reversing some earlier government decisions. If this happens, then a potential ousting of Starmer may be tolerated by the bond vigilantes.

Overall, markets are steady today, as we wait to see if UK CPI and Labour market data will increase expectations that the BOE will cut rates next month. If inflation does moderate as expected, the pound’s losses could be capped, since an interest rate cut would boost the economy and help drive inflows to the Gilt market.

The AI scare trade is on hold as we start a new week. We will need to see the US come back on board before we know if the sell off continues. There is a growing sense that fears about AI swallowing up large swathes of global jobs and industries are overdone and this week could see a recovery in some of the sectors that have seen the worst of the sell off, including software stocks. Investors could also be enticed back, now that valuations are looking much improved compared to 2025.

Chart 1: The dollar vs. the G10 FX space since the start of February. The pound is the only currency to post a loss against the dollar so far in February.

Source: XTB and Bloomberg