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The chart above shows, how the relationship between GBP/USD and 2-year yield divergence has unfolded since 2012.
The cozy relationship between the yield spread and the exchange rate, in this case, is quite visible. Back in 2013/14, UK’s economic prowess and the disappointment that the Bank of England (BoE) governor Mark Carney wasn’t as dovish as expected, fuelled the increase in yield divergence in favor of the United Kingdom and strengthening of the pound against the dollar. But as economic growth slowed and the BoE expressed a greater desire for a cautious approach, yield spread (UK-US) declined and exchange rate softened.
In 2016, the yield spread has declined sharply into the negative since the referendum date was announced. The actual decline began in September 2015 as the market was speculating that the Brexit referendum will be held in 2016, instead of 2017. The yield spread declined from -0.1 percent in September 2015 to -0.4 percent by early 2016.
A week before the referendum the yield spread between 2-year gilt and the 2-year Treasury was trading at -0.36 percent and after it, the decline was very sharp. By October, It declined to -0.65 percent. And the pound has declined from 1.36 against the dollar to 1.25 against the dollar as Bank of England (BoE) introduced several accommodative monetary policy measures including a rate cut. Since the US election that was won by Donald Trump, the yield spread deteriorated sharply to -1 percent.
As a matter of fact, the pound has actually risen since the election. Back in November last year, the pound was trading around 1.235, while the yield spread was at -87 basis points. While the spread has widened further towards -121 basis points, the pound is up trading at 1.272 against the dollar.
In the latest move, the spread has narrowed from -122 basis points in the first week of May to -102 basis points by early July. It is currently at -110 basis points.
While some policymakers at BoE have turned hawkish, the broad direction of the bank hasn’t changed and as the policy direction of the BoE and the Fed are currently divergent, we expect the spread to widen further and the pound to decline accordingly.
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