(from our Weekly Update of 14th February 2017)
Rising inflation in the eurozone is driving real rates lower, widening the rate differential between the EUR and other DM currencies. We look at risk-adjusted real-rate differentials by dividing real-rate differentials by the implied volaility of the relevant fx cross. As the left chart below shows, EUR crosses have shown significant divergence with other DM currencies, in particular we show EURGBP here. The right chart looks at 10y rate differentials between Gilts and Bunds, assuming FX risk is hedged using rolling 3 month FX forwards. Again we can see that the yield available on 10y Bunds is worse than FX-hedged 10y Gilts, showing Bunds are overvalued relative to Gilts. This would favour allocating towards Gilts away from Bunds, which should favour a lower EURGBP.
Clearly there is a lot of uncertainty around Brexit, however, Europe is also experiencing heightened political uncertainty with upcoming elections in France, Germany and the Netherlands. Additionally, there is the risk of an election being called in Italy, which would cause the market to start to price in the risk of Italy leaving the EU. This environment, along with deteriorating support from rate differentials, should favour a weaker EURGBP. (Please click on image to enlarge.)