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 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.
Since the final quarter of 2017, the long-term yield spread and the exchange rate has diverged, which raises the risk of a sharp convergence going ahead. Expect big changes in interest rates going forward.
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 in a neutral mode after ending the asset purchase program last year.
- Inflationary outlook in the United Kingdom due to the recent weakness in the pound.
- Ongoing Brexit negotiations.
The euro is currently trading at 0.873 against the pound. One must note such divergence between spreads and the exchange rate will not be sustainable going ahead. A major directional shift is due.