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Our views 02 August 2019

Number crunching currencies to yields

By Darren Bustin, Head of Derivatives

5 min read

‘Cable’ (sterling against the US dollar) reached a low of 1.2080 today, having collapsed from 1.2439 since Boris Johnson took over as prime minster. As well as semi dovish comments from the Bank of England, this is perceived to be in response to Mr Johnson’s rhetoric about preparing for a hard Brexit. It certainly looks like international investors are doing just that by selling sterling, rather than taking Jacob Rees-Mogg’s guidance on double spacing after full stops and addressing men as Esquire.

What should we expect from yields? Looking at regressions, over the short term, 10 year yields are highly correlated to sterling. Over the last six months, there is a correlation of 88% and an R^2 of 78% (R^2 is a statistical measure used in regression analysis) between sterling declining and 10 year yields declining. The same can be seen in the sterling-euro relationship, where over the last six months the correlation is 86% and the R^2 is 74%. It should be noted that over the last five years the correlation is 84% with an R^2 of 72%, although there are periods where this relationship breaks down. 

If the short-term regressions hold for the near term, the fair value yield of 10 year gilts is forecasted to be 0.56% by the cable regression. For sterling-euro regression, the forecasted yield is 0.65%. This is close to where they are trading today at 0.59%; one might take a view that 10 year gilts are pretty fairly priced!

Economic theory suggests the opposite should happen – as the currency falls, inflation should increase, which makes fixed income unattractive and yields should rise. The issue here is that uncertainty of the future relationship is weighing on the economy, but that uncertainty is not deterring the market from being efficient and pricing gilts ‘perfectly’.

Lower gilt yields aren’t our longer-term expectation (we believe they will rise over the rest of 2019 and into 2020), but the gilts and currency markets are clearly telling us something.

Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice. Portfolio holdings are subject to change, for information only and are not investment recommendations.