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

This chart shows the performance of the 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 the 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 in June 2017. The correlation is currently at -33 percent suggesting a negative impact from the spread widening.

Since our last review in January, the spread has widened from 77 bps to 107 bps in favor of the pound, while it has weakened against the euro by 70 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.
• Ongoing Brexit negotiations.
   

The euro is currently trading at 0.893 against the pound. One must note such divergence between spreads and the exchange rate will not be sustainable in the medium term.