UK Rate Cut Expectations: A Bullish Crossroads for Gilts and GBP Carry Trades

The Bank of England's (BoE) May 2025 rate cut to 4.25%—a narrow 5-4 vote—signals a pivotal shift in its inflation-growth calculus, creating a compelling opportunity for fixed income investors. With disinflation progressing faster than markets anticipate and the labor market softening, we argue that gilt yields are overpriced for the BoE's likely terminal rate path. Simultaneously, the GBP's recent resilience masks vulnerabilities tied to diverging MPC views, making short GBP carry trades a strategic hedge.

The Disinflation Wave: Markets Underestimate the Tide

Breeden's analysis underscores that UK inflation is entering its third wave of disinflation. While CPI spiked to 3.5% in Q3 2025 (due to energy bill adjustments), the BoE's core forecast projects a steady decline to 1.9% by Q2 2027. Crucially, underlying wage growth is cooling, with projections of 3.75% by year-end—well below the 5% peak in early 2024.

This trajectory contrasts with market pricing, which embeds a terminal rate of ~3.5% by mid-2026. However, the BoE's “gradual and careful” approach—coupled with internal dissent favoring deeper cuts—suggests rates could fall to 3.0% or lower. Investors who bet on this gap stand to profit as gilt prices rise.

Labor Market Slack: A Tailwind for Rate Cuts

The BoE's May Monetary Policy Report highlights a “margin of slack” developing in the UK economy, with unemployment forecast to hit 4.7% by Q4 2026. Weak GDP growth (revised down to 0.75% in 2025) and subdued wage growth validate the case for further easing.

Breeden notes that this slack reduces the risk of wage-price spirals, allowing the BoE to prioritize growth without sacrificing inflation control. Markets, however, remain overly sanguine about the labor market's resilience, leaving gilt yields vulnerable to downward revisions.

MPC Divisions: A Catalyst for GBP Weakness

The May vote split—two members advocating 50bp cuts, two preferring no cut—reveals a BoE increasingly comfortable with a dovish pivot. This internal divide amplifies uncertainty, which typically pressures currencies. The GBP has already lost 1.5% against the USD since the meeting, but this could be the start of a broader decline.

Investment Strategy: Play the Gap Between Markets and the BoE

1. Long Gilts (UK Government Bonds):
2. Target: Buy long-dated gilts (e.g., 10Y GB Gilts) as yields are overpriced relative to the BoE's likely terminal rate.

3. Risk: Monitor U.S. tariff impacts on UK trade, which could delay disinflation.

4. Short GBP Carry Trades:

5. Execution: Sell GBP/USD or GBP/JPY pairs, leveraging the BoE's dovish bias and the Federal Reserve's neutral stance.
6. Anchor: Pair this with long positions in higher-yielding currencies (e.g., AUD, NZD) to capture yield differentials.

Timing the Cycle: The Q3 Inflection Point

The BoE's central scenario assumes further cuts through 2026, but the market's pricing of ~75bp reductions this year already reflects this. Investors should focus on Q3 2025, when inflation peaks at 3.5%, likely triggering a more aggressive BoE response. This creates a “buy the dip” opportunity in gilts.

Risks to the Thesis

• Global Supply Shocks: Persistent trade disputes could reignite inflation.
• Labor Market Resilience: A sudden slowdown in unemployment could revive hawkish MPC sentiment.

Conclusion: The Case for Aggressive Action

The BoE's cautious rhetoric masks its willingness to cut rates further as disinflation takes hold. Gilts and GBP carry trades offer asymmetric upside: limited downside risk versus substantial gains if the BoE outpaces market expectations. Investors who act now position themselves to capitalize on one of the most underappreciated opportunities in fixed income markets today.

Act before the market catches up.