The Bank of England has lowered the policy rate by 25 basis points to 3.75%, as expected. This decision was made by a 5-4 vote in favor of the cut and aligns with what the market anticipated, indicating a slow decrease in rates. The Bank forecasts that the UK economy will see no growth in Q4 GDP, with a small underlying growth of about 0.2% from the previous quarter. Inflation is likely to drop quickly towards the target, possibly reaching around 3% by Q1 2026. GDP may grow by 0.1% to 0.2% over the next few years, but fiscal issues could impact growth after three years.

Currency Market Reaction

This decision caused a shift in the currency market, where GBP/USD rose slightly, gaining 0.1% to reach 1.3386. The British Pound had a mixed response against other key currencies, performing particularly well against the Euro. Recent economic data from the UK presents a mixed picture. Inflation pressures are easing, but unemployment is rising. The Consumer Price Index showed inflation fell to 3.2% in November from 3.6% in October. The unemployment rate increased to 5.1%, the highest level in nearly five years. However, business activity improved according to December’s preliminary PMI figures. The Bank of England has cut the policy rate to 3.75%, which we fully expected. However, the close 5-4 vote reflects significant divisions within the committee regarding the future, suggesting that any further cuts will depend heavily on economic data in the coming weeks. This decision appears to be a response to declining economic data over the past month. The latest report from the Office for National Statistics (ONS) in early December 2025 indicated that the UK economy shrank by 0.1% in the third quarter. The Bank now predicts zero growth for the current quarter. With inflation dropping to 3.2% in November and unemployment rising to a five-year high of 5.1%, there is clear pressure to enhance economic support.

Market Implications and Strategy

The Pound’s quick rebound against the dollar indicates that the rate cut was largely anticipated. Now, the market is watching closely for signs that future cuts are less certain, creating risks both ways for the currency. This uncertainty in policy is likely to lead to increased volatility in GBP currency pairs. For derivative traders, this suggests focusing on strategies that benefit from price movements, regardless of direction. We recommend buying at-the-money straddles or strangles on GBP/USD, which involves purchasing both a call and a put option. These strategies will profit from significant price shifts in either direction as we move into the new year. In interest rate markets, the forward curve for SONIA futures will be very sensitive to upcoming inflation and employment reports. The narrow vote means the pricing for the February and March 2026 meetings is likely to be volatile. We see opportunities in calendar spreads to capitalize on changing expectations regarding the timing of potential future cuts. While the BoE is easing rates, we should keep in mind that the US Federal Reserve is expected to cut rates even more aggressively in 2026. Data from the CME FedWatch Tool suggests the market anticipates over 100 basis points of cuts from the Fed next year, in stark contrast to the more gradual cuts expected from the BoE. This policy divergence may help to limit the Pound’s decline against the dollar, making long GBP/USD positions during significant dips an attractive relative value trade. Create your live VT Markets account and start trading now.

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