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, the EUR/GBP exchange rate moved higher to peak in early October around 0.92 area.

In our November review, we suggested a decline in the Euro/Pound exchange rate from 0.89 area to as low as 0.85 as the yield spread widened, which is favorable to the pound. As our target was achieved, the spread also shrank which would be beneficial to the euro. Since November, the spread has shrunken by 28 basis points and currently trading at -0.92 percent.

Still, there is considerable divergence existing between the two and we suspect that it could actually push the EUR/GBP exchange rate lower.

What might affect the yield spread significantly going forward?

• The upcoming elections in Europe.
• The change in outlook from both the Bank of England and the European Central Bank.
• Inflationary outlook in the United Kingdom due to a weaker pound.
• Brexit pre-negotiations

We have forecasted for the exchange rate to decline to as low as 0.8 in the short term.