GBP/USD 2026 Outlook: Can Sterling Sustain Its 2025 Recovery?

Fundamental Analysis

GBP/USD recorded a solid performance in 2025, rising around 6.5%. However, the rally was driven far more by broad US dollar weakness than by outright strength in the pound. This is reflected in sterling’s mixed performance against its major peers. While the US dollar index fell roughly 10% over the year, marking its worst annual decline since 1979, the pound lost ground against the euro and the Swiss franc, while remaining broadly flat versus the Australian dollar and stronger against the Japanese yen.

GBP/USD posted one of its strongest annual advances in recent years, reversing a 1.7% decline in 2024 and delivering its best yearly performance since 2017. The bulk of the gains were concentrated in the first half of the year, coinciding with an aggressive selloff in the US dollar.

The pair rallied from the 1.21 area, a 15-month low, to a four-year high at 1.3790 by early July before consolidating through the summer months. Weakness followed between September and November, although prices recovered into year-end. Looking ahead, uncertainty around how much further the US dollar can decline suggests GBP/USD may struggle to repeat a similarly strong performance in 2026.

UK Economic Outlook

Inflation and wages

UK inflation eased to 3.2% year-on-year in November, cooling more than expected after peaking at 3.8% in September. This was below the Bank of England’s projected peak near 4%. While inflation remains above the central bank’s 2% target, policymakers have acknowledged that CPI is likely to move closer to target by spring as price pressures cool faster than anticipated. The expected deflationary impact from the Budget could further reinforce this trend, increasing the case for a looser monetary stance.

The labour market is also showing clearer signs of softening. The unemployment rate rose to 5.1%, its highest level in almost five years. Wage growth slowed to 4.6%, with private-sector pay falling below 4% for the first time since 2020. While some of the weakness may reflect caution ahead of the Budget, the data suggest underlying labour market slack is building. The BoE expects unemployment to rise further to around 5.5% by Q2 2026 as higher labour costs feed through. Although wage growth is slowing, it remains elevated relative to what would be consistent with the inflation target.

Growth

UK GDP expanded by 0.1% quarter-on-quarter in Q3, slowing from 0.3% in Q2. The OECD forecasts UK growth of 1.2% in 2026, rising modestly to 1.3% in 2027. This points to a slow and uneven recovery rather than a strong expansion. While easier monetary policy and improved confidence may offer some support, fiscal constraints, weak productivity, and global uncertainty are likely to cap growth.

Fiscal outlook

Following the November Budget, immediate concerns around the UK’s fiscal position have eased. Chancellor Rachel Reeves reassured markets by allowing more fiscal headroom than expected, helping to push gilt yields lower. Markets also appeared comfortable with the government’s strategy of front-loading spending while back-loading tax increases. That said, this approach highlights the underlying fragility of the fiscal position. Government spending has remained elevated through the latter part of 2025, and markets will closely monitor borrowing and spending trends in 2026. Sustained high spending could put upward pressure on gilt yields and weigh on sterling, while credible signs of fiscal restraint could offer support.

Political risk

Political uncertainty remains a potential headwind for the pound. Prime Minister Keir Starmer’s position appears fragile, with both he and Chancellor Reeves facing ongoing pressure. While the Budget may have bought time, leadership speculation continues. Poor performance in the May 2026 local elections could reignite challenges to Starmer’s leadership, potentially undermining investor confidence.

Bank of England Rate Outlook

The Bank of England cut rates four times in 2025, and six times in total since beginning its easing cycle in August 2024. Cuts in March, June, August, and November brought the policy rate down to 3.75%.

At its final meeting of the year, the BoE struck a cautious tone, reiterating that further easing is likely to be gradual. The Governor emphasised that policy rates are approaching neutral, limiting room for aggressive cuts. Notably, the stance was unchanged despite softer-than-expected inflation data, reflected in a narrow 5–4 vote.

Markets are currently pricing one additional 25 basis point cut, taking rates to 3.5%. If inflation continues to cool alongside weak growth, the BoE could ease more aggressively toward 3% by the end of 2026. Such a scenario would likely weigh on GBP.

US Economic Outlook

Markets remain cautious on the US outlook, with data distorted by the longest government shutdown on record. Q2 GDP showed annualised growth of 3.8%, the fastest pace since Q3 2023, while Q3 growth is expected to remain solid near 3.2%.

However, labour market conditions are softening. November non-farm payrolls showed a modest 64k job gain following a net loss in October, while unemployment rose to a near four-year high of 4.6%.

US core CPI eased to 2.6% year-on-year in November, undershooting forecasts. While inflation remains above target, a weakening labour market could push price pressures closer to the Federal Reserve’s 2% goal, strengthening the case for additional easing.

Federal Reserve Policy Outlook

The Federal Reserve cut rates three times in 2025, lowering the target range to 3.5%–3.75% by year-end. The latest dot plot points to just one rate cut in 2026, below market expectations for two.

The key question is whether markets are too optimistic. With inflation cooling and labour market conditions deteriorating, the Fed could ultimately deliver cuts closer to what markets are pricing.

Attention is also focused on leadership changes at the Fed. President Trump is expected to announce a new Fed Chair early January, ahead of Jerome Powell’s term ending in May. Expectations that the next Chair may favour lower rates could be contributing to the market’s more dovish outlook.

Conclusion

GBP/USD’s strong advance in 2025 was driven primarily by US dollar weakness rather than broad-based pound strength, raising questions over whether the rally can be sustained in 2026. Cooling inflation and a softening labour market give the Bank of England scope to ease further, while slow growth, fiscal vulnerability, and political uncertainty may limit sterling upside. On the US side, the outlook hinges on whether weakening labour data and cooling inflation force the Federal Reserve to cut more aggressively than currently signalled. While a sharp dollar rebound appears unlikely, GBP/USD may struggle to extend gains meaningfully without clearer UK-specific support.