Fundamental Evaluation Series: Long-term yield spread vs. EUR/GBP

This chart shows the performance of EUR/GBP exchange rate in contrast to the performance of long-term yield divergence between 10-year German bund and 10-year UK gilt.

• During our evaluation period beginning August 2015, we can see that long-term yield difference between the German bund and UK gilts are somewhat going hand in hand with the EUR/GBP exchange rate. While the yield spread topped in late August last year, the EUR/GBP exchange rate moved higher to peak in early October around 0.92 area.
• A very interesting point to note would be the divergence between the long-term rates and EUR/GBP exchange rate. Since the British referendum in 2016, we can visually see that while the spread widened from 62 basis points to 119 basis points in favor of the UK, the pound initially weakened against the euro.
• As the spread narrowed since November last year, from 119 basis points to 77 basis points now, the exchange rate has been in a consolidation phase.
• The 20-day correlation between the spread and the exchange rate declined from a positive 93 percent in August 2016 to just 25 percent as of our review in June 2017.
• In our July 2017 review, we noted that the yield spread has narrowed by 11 basis points in favor of the euro and the euro has increased by 150 pips against the pound.
   

Since then, after spiking in December to -97 bps the yield spread has once again narrowed to just 79 bps. The EUR/GBP exchange rate hasn’t moved much, it is down just 200 pips.

It is clear that other fundamentals are exerting much more impact on the pair than simple rate divergence, which is not surprising given the impact of Brexit on the future of the UK.

What might affect the yield spread significantly going forward?

• Political uncertainties in relation to the current minority government
• The outlook from both the Bank of England and the European Central Bank. Some policymakers have turned hawkish at BoE, which would have a significant impact going forward. ECB is also preparing the ground for tapering.
• Inflationary outlook in the United Kingdom due to the recent strength in the pound.
• Brexit negotiations
   

The euro is currently trading at 0.874 against the pound.