Assessing the Likelihood of a 3.25% Terminal Rate for the Bank of England Amid Fiscal Uncertainty

The Bank of England's Monetary Policy Committee (MPC) has entered a critical phase in its battle to balance inflation control with economic stability. With the Bank Rate held steady at 4% as of November 6, 2025, and inflation lingering at 3.8%-well above the 2% target-the path to a terminal rate of 3.25% by 2026 remains uncertain. While market expectations have priced in aggressive rate cuts, the feasibility of such a low terminal rate hinges on the interplay of inflation normalization, fiscal policy shifts, and global economic headwinds. For UK bond investors, strategic positioning in this dovish environment requires a nuanced understanding of these dynamics.

A Delicate Tightrope: Inflation, Growth, and Policy Divergence

The MPC's recent 5-4 vote to maintain rates at 4% underscores the committee's internal divisions and the complexity of its mandate. Governor Andrew Bailey's preference for "more economic clarity" before easing policy reflects concerns that inflation, though declining from its peak, remains volatile. Inflation dipped to 2.6% in March 2025 but rebounded to 3.8% by September, complicating the case for rapid rate cuts, according to a Bank of England explainer. The Bank's revised growth forecasts-1.4% for both 2025 and 2026-highlight a fragile economic recovery, with weak business investment and rising unemployment further pressuring policymakers, as noted in the same explainer.

Analysts project a gradual reduction in the Bank Rate to 3.5% by early 2026, but the leap to 3.25% would require a sharper easing cycle than currently anticipated. As of October 2025, investors priced in a 75% probability of a 3.75% rate by December 2025 and a 59.8% chance of a cut at the February 2026 meeting, according to a Reuters analysis. Cumulative cuts of 75 basis points by mid-2026 would bring the rate to 3.25%, but this assumes inflation continues its downward trajectory and fiscal policy does not introduce new headwinds, as noted in the Reuters analysis.

Fiscal Uncertainty and the Shadow of the Autumn Budget

The December 2025 Autumn Budget looms as a pivotal event, with Chancellor Rachel Reeves reportedly considering tax increases despite pre-election pledges to avoid raising income tax, VAT, or National Insurance, according to a Morningstar report. Such fiscal tightening could offset monetary easing, complicating the MPC's ability to lower rates aggressively, as the Morningstar report notes. A Bloomberg report notes that even a modest tax hike could dampen consumer spending and inflation, potentially delaying rate cuts, as the Morningstar report notes. Conversely, if the budget introduces stimulus measures, the Bank might face renewed inflationary pressures, further delaying a 3.25% terminal rate, as the Morningstar report notes.

For bond investors, this uncertainty demands a cautious approach. While falling rates typically boost long-duration bond prices, the risk of fiscal policy clashes with monetary easing introduces volatility. The recent drop in two-year gilt yields to 3.769% and 10-year yields to their lowest since April 2025 reflects market optimism about rate cuts, but these gains could reverse if fiscal policy surprises to the hawkish side, as noted in the Reuters analysis.

Strategic Positioning for UK Bond Investors

In this environment, investors should adopt a balanced strategy that capitalizes on rate-cut expectations while mitigating risks from fiscal and inflationary surprises. Three key principles emerge:

1. Duration Management: With rate cuts likely in 2026, extending the duration of bond portfolios could enhance returns. However, investors should avoid overexposure to long-duration gilts, which remain vulnerable to inflation persistence or fiscal tightening. A Schroders report recommends a "neutral" stance, favoring intermediate-duration bonds that balance yield and risk, according to a Schroders analysis.

2. Sector Allocation: The Bank's focus on administered prices and wage growth suggests inflation in services sectors may linger. Investors might overweight inflation-linked bonds (e.g., index-linked gilts) to hedge against this risk. Conversely, sectors sensitive to fiscal policy, such as utilities or public sector contractors, warrant caution if tax hikes materialize.

3. Hedging Against Volatility: Given the MPC's divided stance and external uncertainties (e.g., US tariff policies), investors should maintain liquidity and consider hedging tools like interest rate swaps or options. A Bloomberg analysis highlights that even a 25-basis-point delay in rate cuts could widen yield spreads, creating opportunities for active management, as noted in a Bloomberg article.

Conclusion: A 3.25% Terminal Rate-Possible, but Not Assured

While market expectations lean toward a 3.25% terminal rate by mid-2026, the path to get there remains fraught with challenges. The Bank of England's cautious approach, coupled with fiscal uncertainty and global economic risks, suggests a more gradual easing cycle than currently priced in. For bond investors, the key is to remain agile, leveraging rate-cut expectations while hedging against inflationary or fiscal surprises. As the MPC navigates this delicate balancing act, strategic positioning will be critical to capturing returns in a dovish but volatile environment.