• Fundamental evaluation series: 2-year yield spread vs. GBP/USD

    Source: FxWire Pro - Commentary / 21 Nov 2017 04:40:08   Eastern Standard Time

    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. In 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 had 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 widened further towards -121 basis points, the pound is up trading at 1.272 against the dollar.

    In our review in August, we noted that the spread has somewhat narrowed in favor of the pound as the Bank of England (BoE) gave out a rare signal of a looming rate hike.

    In our mid-September review, we noted that the spread has narrowed by almost 10 basis points, to -99 basis points (UK-US). The pound has moved faster, which is not unusual and has increased by almost 690 pips since our review in August and was trading at 1.356 against the dollar.

    We further noted in October that the spread has widened by more than 14 basis points to 113 favor of the dollar and the pound has weakened by 340 pips and to 1.322 against the USD.

    Since that review, the spread has widened by almost 15 bps in favour of the dollar to 128 bps, while the pound has strengthened by 30 pips to 1.325 thus adding to the divergence.

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