The Pound Sterling has been supported by high UK yields, but analysts warn that falling energy risks and softer domestic conditions could pull both rates and the UK currency lower.
Pound Sterling has held up reasonably well while UK bond yields have climbed, but foreign exchange analysts at MUFG think that support may prove less reliable than it looks.
The British Pound gained around 0.75% against the US Dollar (GBP/USD) over the past week and was little changed against the Euro (GBP/EUR).
Its performance elsewhere was far less convincing, with losses against the Australian and New Zealand Dollars and a particularly sharp fall against the Yen.
MUFG says the rise in UK yields has been central to Pound Sterling’s resilience.
“Yield support has underpinned Sterling resilience,” the bank said, after the ten-year Gilt yield jumped 29 basis points in July to close at 5.05%.
The front end of the curve also moved sharply.
Two-year Gilt yields finished the month around 65 basis points above Bank Rate as traders increased bets that the Bank of England could tighten again.
There is a catch.
“We suspect the move at the front-end of the curve is now overdone,” MUFG said.
The Bank of England’s dilemma is fairly plain.
Higher energy prices have raised the risk of another inflation shock, but the domestic economy is hardly crying out for tighter policy.
“Weak domestic economic conditions are proving disinflationary but are being offset by upside inflation risks from abroad related to energy and the conflict in the Middle East,” MUFG said.
If the conflict de-escalates and energy prices fall, the case for further tightening would weaken quickly.
Gilt yields could then retreat, removing one of the Pound’s main props.
“If there is de-escalation and a decline in upside inflation risks, UK yields should fall and take the Pound lower,” the bank warned.
The alternative is not especially attractive either.
A fresh energy surge could force the Bank to raise rates, but MUFG doubts that hiking into a weak economy would be particularly helpful for Sterling.
“If the conflict worsens and energy prices rise further, a rate hike is possible, but hiking into weak domestic economic conditions is unlikely to be currency supportive.”
Pound Sterling Outlook: Higher Yields Do Not Guarantee a Stronger Currency
MUFG expects the Bank of England to remain on hold, arguing that markets are pricing more tightening than policymakers are likely to deliver.
“We view the UK rates market as overpriced for what the BoE delivers,” the bank said. “If they hike, it will still be less than currently priced.”
Sterling remains below its starting level on the one-month major-currency index, despite support from elevated UK yields.
There is also a familiar UK vulnerability in the background. The country still depends on foreign capital to finance its current-account deficit, leaving the Pound exposed when markets become unsettled.
“Higher volatility in FX and risk assets would likely coincide with Pound depreciation,” MUFG said.
That is why the yield story can cut both ways.
High rates may support Sterling while markets are calm, but they can just as easily become a warning sign if they reflect inflation anxiety, fiscal concerns or deteriorating confidence.
GBP outperformed the Dollar and Canadian Dollar over the week, while losing ground against higher-beta currencies and the Yen.
MUFG expects GBP/USD to ease to 1.3260 in the third quarter before recovering gradually, while EUR/GBP is forecast to rise from 0.8547 to 0.8800 by the second quarter of 2027.
The bank’s conclusion is cautious rather than aggressively bearish: Sterling’s yield advantage is real, but it may disappear just as investors have grown most comfortable relying on it.
