06:29 AM EDT, 07/09/2025 (MT Newswires) -- The outlook for sterling, the thrid-worst performing G10 currency in July, has worsened with increased risks of a period of underperformance ahead, according to Mitsubishi UFG.

MUFG expects to start seeing an increase in the monthly flow of United Kingdom economic data from Friday, when markets will have the gross domestic product data for May, along with manufacturing activity and trade. The 0.3% GDP contraction in April, along with the 109,000 plunge in pay-as-you-earn employment, plus a much weaker retail sales report, underline the prospect of a sharp slowdown in Q2 GDP after the 0.7% quarter-over-quarter gain in Q1.

The 6-3 vote to maintain an unchanged policy at the June Monetary Policy Committee meeting also shows the Bank of England could be more open to a faster pace of rate cuts if the current weak momentum continues, MUFG wrote in a note to clients.

There have also been signs of instability in the Gilt market and there has been a steady negative correlation between GBP performance and the direction of long-term Gilt yields, underlining the negative investor sentiment toward the Gilt market, pointed out the bank.

That won't have been helped by the release on Tuesday of the Office of Budget Responsibility report on the annual Fiscal Risks and Sustainability, noted MUFG. Each year the OBR addresses certain themes impacting fiscal sustainability risks and this year, one aspect looked at was the changing pension industry, that are a negative for the Gilt market.

The executive summary opens with some grim facts that underline the potential for further market disruptions given the sensitivity of investors to any bad news on the fiscal outlook. At 5.7% of GDP at the end of 2024, the United Kingdom's budget deficit was 4.0ppts higher than the advanced-economy average and was the fifth highest -- after only France, Slovakia, the United States and Israel.

With the 10-year Gilt yield at 4.5% at the end of H1 2025, the U.K. government faces the third-highest borrowing costs of any advanced economy after New Zealand and Iceland, added the bank. One of the conclusions related to the pension industry is that the shift from Defined Benefit schemes to Defined Contributions will mean over time that pension holdings of Gilts will drop from around 30% of GDP to about 10% in the 2070s.

In the near term, the U.K. government has got itself into a fiscal "mess," according to MUFG. The election promise not to raise taxes on "working people" meaning no tax increases on income, national insurance or VAT (sales tax) was a "big mistake" in hindsight and will likely be broken to fill the estimated 25 billion pounds fiscal hole.

Without a credible big step measure -- a wealth tax and/or a freeze on income tax thresholds are rumoured -- a credibility gap will persist and risk further dangerous market disruptions. Sharp Gilt sell-offs, like recently, will be sterling negative and potentially very disruptive. Action to address the fiscal hole will ultimately prove to be negative, but will be less disruptive and more palatable, said the bank.

In that scenario big tax increases into an already slowing economy will encourage a faster pace of rate cuts from the BoE, estimated MUFG. Either way, the risks for the sterling are shifting and the outlook is worsening.