The Sterling Pound, Great Britain Pound, or just British Pound (GBP for short) is the currency of the United Kingdom.
Issued and managed by the Central Bank of the U.K., the Bank of England, the Sterling Pound has remained one of the most traded currencies in the world.
Why? Because of the relevance of U.K.’s economy in world trade, and being the financial services capital of the world (along NYC).
Note: this is changing rapidly. since the announcement of Brexit, many global banks have moved or begun the process of moving their European headquarters out of the U.K.
After all, who doesn’t love that British accent? I know I do.
But on a more serious tone, what drives Sterling Pound (GBP) price in FX markets?
Like with every other currency, the major drivers will be:
1. How well the issuing economy is doing.
2. What the Central Bank is doing.
Tell me more…
In the case of the U.K., we can see how the whole Brexit phenomenon has affected #1.
Is the economy doing badly?
It is more a matter of uncertainty. It is incredibly hard to forecast what’s going to happen with GDP, production, and other important macro variables.
Also, financial services, one of the most important sectors (though, far from being the only one) has been dismembered, with many big players choosing to leave the U.K. Or at least, diminish their presence.
Thus, since this event has, for the most part, being perceived as negative, Sterling Pound has lost ground against other major currencies (depreciated).
Had U.K. stayed in the EU, and had its economy continued to perform wonderfully (leading the way, you could say), GBP would likely have remained strong.
This is a simple case of strong economy = strong currency. The reverse is often also true.
But we can’t oversimply things that much. When a currency devalues, exports often increase since goods and services become cheaper to foreign buyers.
Sadly, this mechanism isn’t always a clear advantage, since such a depreciation makes imports more expensive.
When producers pay more to import materials, they frequently pass some of that cost to consumers in the form of higher prices.
Therefore, a devalued currency makes imports more expensive, which then makes prices grow (inflation).
If wages remain stagnant, people will have less purchasing power.
And this, is what U.K. is going through as I write this piece.
Ok, but… the initial depreciation already occurred, what now?
Glad you asked.
With increasing inflation, the Bank of England (BoE), whose mandate is to curb inflation, will consider hiking rates (which would increase GBP price).
And that’s exactly what the BoE has done. With inflation readings above 2.5% for several months, it begun to consider hiking rates.
The markets got crazy and GBP pairs started rallying (in favor of the Sterling Pound).
However, due to the decrease in purchasing power for Britons, and because of the heavy uncertainty Brexit remains to pose, the BoE decided to wait and see.
After this (disappointing to haws) news, GBP fell again.
In other words, had you stayed on top of the Bank of England’s decision-making process/rational…
And had you kept a watchful eye on the economy when Brexit occurred (the referendum) …
You could have made some serious pips.
These examples are relatively recent, but the principles remain the same for other circumstances.
Obviously, Brexit is too big an economic event. Hence, for the most part I would pay attention to Driver #2.
As I just mentioned, when it comes to GBP moves, it is best to focus on the Bank of England.
If you do this, and you do it well, then you will, by default, have an eye on the economy as well.
The Bank cares mostly about inflation, true. But as we saw with the previous story, the economy’s health will impact the Bank’s assessment.
And since the Bank of England (BoE) follows how the economy is doing… It is only natural for you to be exposed to that as well, as you try to stay on top of developments in FX markets.
But just to be extra clear, in most cases inflation in the U.K. will be the biggest driver of GBP price.
This is because that’s what the BoE really cares about.
In our true example above, other variables matter more than usual because they were affecting price stability (inflation) in real terms (lower purchasing power).
And in that case, hiking rates to curb inflation wasn’t going to help (because it decreases economic growth).
Thus, hiking rates would decrease nominal inflation, but it would also decrease an already slow growth, which means wages wouldn’t grow.
Therefore, we’d be right where we started.
This likely happened because Brexit weakened economic growth enough so wages lagged to increase with a higher inflation.
But I’m getting into the weeds here. And some might disagree.
The point: pay attention to monetary policy which cares mostly about inflation in the U.K. This is what drives GBP price first and foremost (rate changes).
See you soon,
The Forex Economist
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