* Sterling stays low on UK composite PMI
* Indicator contracts for first time since 2016
* Markets continue to expect a rate cut in next 12 months
* Selection of new EU officials could make UK Brexit talks tougher (Updates prices, adds quotes, new context)
By OLGA COTAGA
LONDON, July 3 (Reuters) - Sterling and gilt yields fell on Wednesday as economic data reinforced money markets' view that the Bank of England would join its central bank counterparts in cutting interest rates to shore up a worsening economic outlook.
The U.K. composite purchasing managers' index fell to 49.7 in June from 50.9 in May, slipping into contraction territory for the first time since mid-2016 due to gloomy manufacturing and construction PMIs. Services PMI just stayed around 50, coming in below-forecast
The data "underpins the type of concerns that (Mark) Carney is projecting," said Jane Foley, senior forex strategist at Rabobank.
Sterling slipped 0.2% to $1.2572, having touched a two-week low of $1.2558 earlier in the day. Against the euro, sterling fell 0.2% to 89.75 pence .
"The 90 level (in euro-sterling) looks a little more vulnerable than it did before," said Foley, noting the level had been unsuccessfully tested recently. "Psychologically, 90 for euro-sterling is very important."
UK government bond yields fell sharply on Tuesday after BoE Governor Mark Carney flagged uncertainties stemming from trade disputes and Britain's departure from the European Union.
Markets interpreted the comments as dovish, pushing 10-year British government bond yields under the BOE policy rate of 0.75% for the first time in a decade. Participants have nearly priced in a 25 basis-points rate cut in the next 12 months.
In another sign of market concern, two-year yields fell below the five-year one for the first time since August 2008, a curve inversion that can herald an economic downturn.
"It looks like the BoE is lining up a more realistic view on Brexit. If Brexit is delayed again it looks like Carney is potentially teeing up a rate cut," said Colin Asher, senior economist at Mizuho.
Markets also remain concerned over Britain's chances of striking a Brexit withdrawal deal with the EU before the Oct. 31 departure deadline.
The governing Conservative Party is due to name either Boris Johnson or Jeremy Hunt as its new leader on July 23, but analysts say whoever then becomes prime minister is unlikely to have enough time to renegotiate a deal with Europe before the Halloween deadline.
The new prime minister would also have to deal with Ursula von der Leyen, the German nominee to become European Commission president. Von der Leyen has been scathing about the referendum campaign run by Brexit-leaning UK politicians.
"It looks like she isn’t going to give an inch in respect to" the new British prime minister trying to renegotiate a deal with Europe, said Rabobank's Foley.
Reporting by Olga Cotaga; editing by John Stonestreet and Jon Boyle