Pound's Yield Advantage May Be Short-Lived Amid Energy Risks and Soft Domestic Conditions

The British Pound has held its ground against other major currencies despite high UK yields. However, analysts at MUFG warn that this support may not last due to falling energy risks and softer domestic conditions.

MUFG notes that the rise in UK yields has been a key factor in the Pound's resilience, with the ten-year Gilt yield increasing by 29 basis points in July to close at 5.05%. The front end of the curve also moved sharply, with two-year Gilt yields finishing the month around 65 basis points above Bank Rate.

Despite this, MUFG suspects that the move at the front-end of the curve is now overdone, and that a decline in energy prices or a de-escalation of the conflict in the Middle East could lead to a fall in UK yields and a subsequent drop in the Pound's value.

The Bank of England faces a dilemma, with higher energy prices raising the risk of another inflation shock, but domestic economic conditions being weak enough that tighter policy may not be necessary. If the conflict worsens and energy prices rise further, a rate hike is possible, but MUFG doubts that hiking into a weak economy would be particularly helpful for Sterling.