UK in dire straits after finance minister's tears rattle markets

All eyes are now on the U.K.'s ruling Labour Party for any sign of further political fractures that could rattle Britain's economic stability, after the extraordinary sight of the country's finance minister crying in parliament on Wednesday.

U.K. bond yields spiked and the pound sank against the dollar and euro as Prime Minister Keir Starmer failed to back Chancellor Rachel Reeves during a question and answer session in the House of Commons. Tears fell down Reeves' face, while Starmer appeared unaware of her distress behind him.

U.K. bond yields spiked and the pound sank against the dollar and euro as tears fell down Reeves' face, and as an apparently unaware Prime Minister Keir Starmer failed to back her when asked about her position during a heated parliamentary debate.

The market moves were abrupt, as traders speculated that Reeves could be about to lose her job or potentially resign, taking her strict "fiscal rules" on spending and borrowing with her.

"There are a lot of eyes on the U.K.," Simon Pittaway, senior economist at the Resolution Foundation, told CNBC as the drama unfolded Wednesday.

"When it comes to the [next] Autumn Budget, whoever the chancellor is, they'll have some really difficult decisions to make. And I think, as far as we're concerned, sticking to the existing fiscal rules is really crucial, that's a move that would signal kind of credibility and confidence to the market" at a time when the country is under heavy scrutiny, he told CNBC's Ritika Gupta.

"Sticking to those fiscal rules, and depending on the government's priorities, some combination of higher taxes and lower spending, out towards the end of the forecast period might be the way forward," Pittaway said.

The government scrambled the calm the situation amid spreading market tumult, with a spokesperson attributing Reeves's distress to a "personal matter" without commenting further. The prime minister then told the BBC that he and the chancellor were "in lockstep" and that he fully backed her.

The comments seemed to placate markets, with London's FTSE 100 up almost 0.5% in early deals on Thursday morning, with the British pound also higher against the euro and dollar. The yield on the U.K.'s benchmark 10-year bonds, known as gilts, was down 6 basis points.

Reeves has come under sustained pressure since the last Autumn Budget, during which she unveiled a massive boost to public spending that would be largely funded by a big tax hike on British businesses and employers.

She also said she would be implementing two fiscal rules to get the U.K.'s debt pile and borrowing under control: firstly, that day-to-day government spending will be funded by tax revenues and not by borrowing, and, secondly, that public debt will fall as a share of economic output by 2029-30.

The rules gave Reeves' Treasury little fiscal "headroom," however, and the little leeway she did have has been further eroded by the government rowing back welfare spending cuts in recent months.

After another government U-turn this week, this time on disability benefits, Reeves must now find savings elsewhere — tricky, when she's just announced a massive public spending plans — break her borrowing rules or go against Labour's campaign pledges and hike taxes on workers later this year.

On a wider level, following the latest climbdown on welfare, the Labour Party leadership will now have to wrangle with a rebellious group of backbench lawmakers who will feel emboldened to challenge the government on other potentially controversial reforms and spending cuts.

"The nature of what's happened over the last 48 hours, with the government's welfare bill being torn up, it means that the government's political and economic strategy are in absolute dire straits at the moment," Max Wilson, director of public affairs at Whitehouse Communications, told CNBC on Thursday.

The government finds itself with "such little wiggle room" because of its previous political decisions and concessions to backbenchers, Wilson said.

"Financially, economically, there's very little that they can do, and Rachel Reeves has such a tough job on her hands now, finding the extra money without resorting to other actions that are going to upset the markets, including borrowing more or tax rises, so, really, I think the government left in an absolute bind here," he noted.