The British Pound or Pound Sterling, the home currency of the United Kingdom, is the oldest actively traded currency in the world. London is one of the largest forex hubs in the world. The pound is the third most commonly held reserve currency, the sixth-largest currency by GDP and the eighth largest in purchasing power parity.
Balance of payments (BoP)
This is an accounting record of a country’s economic relationship with the world. The BoP is made up of 3 main accounts: the current account, the financial account, and the capital account.
The performance on the market of a country’s currency is largely affected by the current account and forex traders has a great interest in this. The current account shows the quantities a country is importing and exporting, the flow of income and the transfer of payments.
A current account surplus, indicates more capital flowing into the country, and this influences the currency positively. Investor confidence then naturally increases, and this helps the currency appreciate. A current account deficit indicates that more money is going out of the country because the country is spending more on foreign goods. The impact on the currency value is determined by the size of the deficit. The current account report of the UK is released quarterly.
The current account balance of the UK in Q3 2020 was £15,734 million. Exports grew by £21.4 billion while imports increased by £17,5 billion. The trade surplus increased to £6.9 billion after inflation was factored in.
The political stability of a nation has a massive effect on the value of its currency. When significant changes are expected in a country’s government, investors are less likely to be interested in its currency.
Here are some examples to illustrate the point:
During the 2014 referendum on Scottish independence, there was significant volatility in the GBP/USD currency pair. The GBP hit a short-term low but recovered quickly.
Brexit also affected the GBP significantly. Immediately after the British referendum in 2016 to leave the EU, the GBP performed poorly against the USD and the euro. The GBP fell again after the re-election of Jeremy Corbyn.
The GBP recovered slightly in 2017, however it sank again with the possibility of a no-deal Brexit on the horizon. When Minister Theresa May resigned in May 2019 the situation became worse. In August 2019 the GBP hit a 10-year low against the euro.
The Brexit surrounding uncertainties increased the volatility of the GBP. However, as soon as a Brexit deal was reached the GBP recovered a level of certainty and the currency remained relatively stable.
A currency value is affected by economic conditions.
Countries with high inflation levels, generally see a depreciation in their currency value in comparison to other countries. This is because consumers have lower purchasing power. The central bank of a country raises short-term interest rates during high inflation to decrease the inflation effects and stabilise price levels. A currency value is boosted by low inflation due to an increase in a country’s purchasing power. This leads to increased global demand for that currency.
The level of a country’s inflation is distinctly affected by consumer prices. The Bank of England uses the Consumer Price Index (CPI) to estimate its inflation target. The CPI is a report compiled by the Office for National Statistics that calculates changes in the prices of goods and services bought by consumers within a certain period.
The inflation target of the government sets the price stability objective. It is a 2% annual growth in the Retail Prices Index excluding mortgages (RPI-X). Simply stated, if inflation is 2%, it means that prices are 2% higher this year than the year before. The Bank of England adjusts inflation to meet this target set by the Treasury.
A deviation from the inflation target affects future monetary policies and interest rates. Changes in the CPI which differ from the Bank of England’s inflation target can cause future monetary policy action which may significantly affect the GBP. A high inflation rate in the UK may lead to higher retail prices as the Bank of England adjusts rates to match the inflation. In July 2019, the 2.1% rise in inflation was the highest in almost two years. The Producer Price Index (PPI) is also used by the Bank of England as an inflation indicator. The PPI shows how changes in inflation affect raw materials, which in turn affects consumer prices.
Central Bank Policy
The Central bank policy in any country influences the exchange rates. The Bank of England controls interest rates and money supply, which can deflate or inflate the GBP. The June 1997 Bank of England Act gave the bank operational independence to set monetary policies and deliver price stability. The monetary policy executed by the bank is critical to promote monetary stability and support the government’s growth.
The policy keeps inflation low and builds confidence in the currency. When the stability of the GBP is threatened by inflation, the bank uses monetary policy tools to control it.
This Central bank can also use foreign exchange reserves to ensure the domestic currency trades at a fixed rate against other currencies.
Changes in the monetary policy have a direct impact on the bank rate. The monthly bank interest rates are determined by the Monetary Policy Committee (MPC).
The exchange rates are directly also affected by policy changes, especially the GBP currency pairs. These include GBP/EUR, GBP/USD, and GBP/CAD. The most liquid currency pair of these three is the GBP/USD, according to financial experts. A liquid currency can be quickly exchanged for another asset or sold at the market price. If the US Federal Reserve Bank was to raise interest rates but the Pound remained stable, the two countries would have an interest rate differential. Lenders may invest more in a nation whose interest rates are higher because of the possibility of high returns. Market participants may also invest foreign capital into the country, pushing the currency value higher.
A strong economy is worth investing in, therefore countries with strong economies have strong currencies. As the local currency is needed to invest, demand increases and this boosts the value of the currency.
GDP is used as the primary measure of the overall level of economic activity by the UK. Currency values can therefore be significantly altered by GDP. Three GDP reports can affect the trading capacity of the GBP. These are the Preliminary GDP, the Revised GDP, and the Final GDP.
The biggest impact is usually made by the Preliminary GDP. Its earlier release provides a glimpse into the economic health of the UK. However, it’s the least accurate because it’s revised twice—in the Revised GDP report and then in the Final GDP report. The GDP report is generated quarterly, so many financial experts supplement the report with other economic activity indicators. These include retail sales and the Manufacturing and Services Purchasing Managers’ Index (PMI). Due to the fact that consumers are the drivers of economic activity, retail sales have larger importance.
Confidence in the British Market
Monitoring the confidence and sentiment in the market is important as it helps to determine the optimism or pessimism of people related to the economy. Reports that measure market sentiment focus on highlighting changing economic trends which can affect the value of the GBP.
Traders analyse whether the majority of the people are optimistic or pessimistic and through this, they detect shifting trends. Both changes and the magnitude of those changes in pessimism or optimism directly affect the GBP.
A snapshot of the economic environment is provided by surveys, the Nationwide Consumer Confidence Index, and GfK Consumer Confidence. These surveys contain five questions about employment, the general economic environment, and future expectations. The surveys help traders forecast which way the UK economy is headed.
The time period assessed is the key difference between these two reports. The Nationwide Consumer Confidence Index measures the respondents’ outlook on their current situation and their expectations for the next six months. Therefore this survey is using the current outlook to forecast the next 6 months. The GfK Consumer Confidence survey examines the respondents’ feelings about events that occurred in the last 12 months and their expectations for the next 12 months. This survey considers the past to forecast expectations for the next 12 months. Both reports offer a useful way to assess sentiment towards the direction of the UK economy.
The confidence of the population in the economy is determined by the state of UK politics in general and the Prime Minister in office.
There are multiple factors that move the GBP. Some factors directly affect the currency and others are based on speculations by traders and consumer behaviour. Changes definitely happen quickly and can be difficult to predict.
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