A View from the Bridge - February 2026

With political turmoil or “Polycrisis” inside Downing Street being the more dominant theme for sterling markets over the past couple of sessions, market participants were not primed for a pronounced shift in bias from the Bank of England’s Monetary Policy Committee (MPC)at their first meeting of the year. A spilt decision to hold rates at 3.75% (5 hold, 4 to cut 0.25%) caught traders off guard! The turn up in business sentiment indicators since the November budget and the “near neutral” communication following the December meeting had previously left the next 25bp cut not fully priced until the June meeting at the earliest.
Unusually. this was a consecutive meeting of the MPC where Governor Bailey used his casting vote to set the policy rate, having previously voted for the 25bp in December. The shift in bias was based upon two key judgements; firstly being that the risk from greater inflation persistence has become less pronounced and, secondly, the lower growth outlook (0.9% vs 1.2% in 2026) and higher unemployment forecasts (5.3% vs 5.0% by Q2). The outlook for inflation over the next six months was notably lower than forecast in November, primarily reflecting developments in energy prices (including cuts to green levies) and fiscal measures announced in the Budget. The combined effect is inflation 0.7% lower by Q2 2026 leaving it close to the 2% target by April, 12 months earlier than had been predicted at the November forecast round. Household inflation expectations respond to energy and food prices in a salient manner, suggesting that wage and price-setting could normalise more rapidly. Notably, the BOE Agents survey showed pay settlements slowing to 3.4% in 2026, some 2% below its 2024-25 average and economically consistent with the 2% inflation target being sustained. The Bank is signalling a more neutral policy rate on the horizon which has that “goldilocks” effect on the economy, supporting steady demand and supply growth and the 2% inflation target at the 2- to 3-year forecast horizon.
Market pricing is now at levels where it sees more two-way risk at the 1- and 2-year forward horizon. After being inverted for over 3 years today’s close marks the first time since June 2023 that the spread between 2- and 1-year SONIA rates has returned to zero as can be seen below. Implied volatility is at the lowest levels since the pandemic, so those looking to hedge interest rate risk but retain some exposure to the prospect of rates continuing to fall below 3% should continue to monitor interest rate cap pricing versus fixed rate accordingly.
We continue to believe the MPC central tendency is around 3.0-3.5%, or a further 0.25%-0.75% of base rate cuts. With inflation now expected to fall more quickly towards the 2% target and unemployment moving higher, the BOE have signalled this move to neutrality can happen sooner. The market reacted accordingly, pricing a 60% chance of a 25bp cut by 19th March, rising to 92% by 30th April. The probability of an additional 25bp cut to 3.25% was 73% by the November meeting.