EUR/GBP hinges on yield spread

September 20, 2016 01:00 PM
The British pound/Japanese yen (GBP/JPY) and the GBP/U.S. Dollar currency pairs tanked following the Brexit vote, falling 20% and 15% respectively after the June 23 referendum.

The British pound/Japanese yen (GBP/JPY) and the GBP/U.S. Dollar currency pairs tanked following the Brexit vote, falling 20% and 15% respectively after the June 23 referendum. The prospects of further declines of the same magnitude may have receded, but what about the Euro/GBP rate?

The euro rose 14% in the nine sessions following the referendum. Yet, the euro was seen by many as the least attractive option against the pound because the Eurozone would suffer along with the UK from a Brexit. In currencies the scope for monetary policy differentials remains the most vital force. On the monetary policy front, the Bank of England finally cut rates and dove back into quantitative easing. The BoE cut its base rate by 25 basis points to 0.25%, raised purchases of government bonds (gilts) by £60 billion to £435 billion and purchased £10 billion in corporate bonds of select companies. If there were any doubts about the future of economic growth, the central bank slashed its 2017 gross domestic product outlook to 0.8% from 2.3% -- the biggest downgrade in more than two decades. 
 
Considering the outlook for further growth slowdown and expansionary monetary policy, UK 10-year gilt yields plunged to record lows of 0.50% while their German counterparts have recovered off their -0.20% lows. When tying currencies to yield differentials, “Follow the money” illustrates that 10-year gilt yield advantage versus bund yields is at its worst level in more than three-years, highlighting the positive correlation between the German-UK spread and EUR/GBP cross rate. Expectations of further BoE easing could send the gilt-bund spread into positive territory for the first time in five years. The German-UK 10-year spread does not necessarily need to be positive for the EUR/GBP to push higher -- further narrowing of the bund yield advantage will suffice. Adding technicals to the yield spread, we note the 100-week moving average is on its way to possibly crossing above the 200-week moving average, which would trigger the bullish golden cross formation as was witnessed in 2007. 

The scope for further GBP/EUR declines is also founded on fundamental differentials. The UK’s current account deficit of 5.7% of GDP and budget deficit of 4% of GDP strike is similar to when the U.S. current account deficit stood at 4.5% of GDP and the budget deficit at 5.5% in 2003-04. With the U.S. twin deficits totalling about 10% of GDP in 2003 and the dollar having already fallen 20%, USD went on to lose another 20% into 2008 as the deteriorating current account and budget rattled the dollar. With the UK’s twin deficits currently standing near 10% of GDP, compared to Eurozone twin deficits of 0.10% of GDP, there is room for fresh GBP damage following the 16% decline in trade-weighted terms. The budget deficit should deteriorate further as the UK Treasury plans to drop the ball on spending cuts, seeking to cut corporate taxes from 20% to 15%. 

Further rate cuts and QE will exert punishment on the GBP when widening current account deficits means money capital flows must be encouraged to stay in the country. 

On the trade front, 45% of British exports go to the European Union while only 6% of EU goods go to Britain. Guess who needs whom? Now that the UK’s trade agreements with the rest of the world under the EU will be void, the UK has to renegotiate trade agreements with 50+ nations and face EU negotiators, who will not be making extra efforts to accommodate the UK’s trade demands.

The EUR/GBP graph atop the yield spread suggests a breakout above 0.95 pence is a strong possibility as long as the spread continues to near positive territory. And with the eight-year old downward channel finally broken, euro bulls will have more to smile about as the 0.9770 pence target looms ahead.

About the Author

Ashraf Laidi is chief global strategist at City Index-FX Solutions and author of “Currency Trading & Intermarket Analysis.” His Intermarket Insight appears daily on AshrafLaidi.com.