BNP Paribas forecasts UK growth slowing to 0.7% in 2026, down from 1.4% in 2025, after a projected +0.4% q/q in Q1 that would leave the average quarterly pace at about +0.1%. The bank links the weaker outlook to inflation pressures stemming from the Iran conflict. Inflation is seen reaching 3.6% y/y before easing only gradually to 3.3% y/y in 2027, keeping it above the Bank of England’s target.
Against that backdrop, the bank expects policy to pivot from an easing path to a 50 basis-point tightening in 2026. It also sees 10-year gilt yields staying elevated through 2026, then falling to 4.30% in 2027 as net supply declines, political risk premia compress and markets begin to price in potential Bank of England rate cuts. In foreign exchange, BNP Paribas projects USD/JPY at 160 and GBP/USD at 1.35 by Q4 2026, with both pairs expected to remain broadly stable through 2027.
Interest Rates, Inflation, and Gilt Market Implications
We see the UK economy slowing for the rest of 2026, yet inflation is set to rise again due to conflict in Iran. This forces a change in monetary policy, shifting from expected cuts to potential rate hikes. Derivative traders should reposition for higher interest rates than the market was pricing in just weeks ago.
With the market now needing to price in 50 basis points of rate hikes this year, we should be looking at short positions in UK gilt futures. The expectation for 10-year yields to remain elevated around 4.3% suggests bond prices have limited upside. This view is supported by historical periods of stagflation where central banks were forced to hike into a slowing economy, pressuring bond valuations.
FX Outlook, Inflation Trades, and Equity Market Strategy
We anticipate the pound strengthening against the dollar, with a target of 1.35 by the fourth quarter. Given that GBP/USD is currently trading near 1.27, this represents a significant appreciation for sterling. In the coming weeks, we would consider buying call options on GBP/USD to profit from this expected move.
Inflation is poised to re-accelerate towards 3.6%, a concerning jump from the most recent Office for National Statistics report showing CPI at 2.3%. This renewed risk of high inflation makes inflation swaps an attractive position. We believe the market is underpricing this potential for a second inflationary wave this year.
The combination of slowing growth and higher borrowing costs will squeeze corporate profit margins, particularly for domestically focused companies. This outlook is negative for UK equities, which have already seen earnings growth slow over the past year. We would therefore look to buy put options on the FTSE 250 index to position for a potential market downturn.
