MUFG Says Bank of England Rate Cuts, Domestic Political Risks Could Reinforce Sterling Weakness in 2026

09:10 AM EST, 12/31/2025 (MT Newswires) -- Sterling (GBP) has underperformed relative to other European G10 currencies in 2025, said MUFG.

EUR/GBP has trended higher for most of the year after establishing lows between 0.8200 and 0.8250 in late 2024/early 2025. This move has ended the two-year downtrend that persisted through 2023 and 2024, wrote the bank in its "G10 FX 2026 Outlook" note posted this week.

MUFG expects the GBP to weaken further against the euro (EUR), with EUR/GBP rising closer to 0.9000 in 2026. The last time EUR/GBP traded at those levels was in the aftermath of the negative fiscal shock from former Prime Minister Liz Truss's mini-budget between September 2022 and February 2023.

In contrast, the GBP should hold up better against the US dollar (USD) given the bank's outlook for broad-based USD weakness.

MUFG's forecast for a weaker GBP against the EUR reflects two main drivers. Firstly, it estimates the Bank of England to continue loosening monetary policy in 2026, while the European Central Bank is likely to keep rates on hold.

The narrowing yield differential should erode the carry appeal of the GBP. The BoE signaled this week it plans to slow the pace of rate cuts as the policy rate approaches neutral. After delivering four quarterly cuts in 2025, MUFG forecasts two or three additional cuts in 2026, bringing the policy rate closer to 3.00%.

Concerns over persistent inflation risks in the United Kingdom should ease further amid a loosening labor market. Headline inflation is set to move back toward the BoE's target during the first half of next year, partly due to government Budget measures. Slowing wage growth would give policymakers more confidence to lower rates further.

Secondly, the GBP is likely to be undermined by renewed fiscal and political risks, added MUFG. The recent Budget was well received by the gilt market and helped dampen speculation of an immediate leadership challenge within the ruling Labour Party.

However, these risks are likely to resurface in the first half of next year, ahead of local elections in May. A poor Labour Party performance could embolden potential challengers to Prime Minister Keir Starmer.

A leadership contest could trigger GBP selling, reflecting concerns that a more left-leaning candidate -- such as Manchester Mayor Andy Burnham or former Deputy Prime Minister Angela Rayner -- might become the next prime minister, according to the bank. This could heighten concerns over the Labour government's tax-and-spend policies at a time when the fiscal deficit remains unusually elevated during an economic expansion, at around 4.5% of gross domestic product.

Political developments have the potential to spark a period of heightened GBP volatility, said MUFG.

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