March 31, 2021 — 8 min read
The Pound sterling (the British Pound) is the United Kingdom’s home currency. It's one of the most traded currencies on the foreign exchange (forex) market and also the oldest actively traded currency.
The Pound also is the third most commonly held reserve currency, the sixth largest currency by GDP, and the eighth largest in purchasing power parity. It's one of the most financially and economically important currencies worldwide. Its popularity is also due to the fact that London is among the largest forex hubs globally.
Here at Xe, the Pound is one of the top currencies sent by our customers. If you frequently send Pounds or have plan to do so, you might be wondering: what causes changes in the Pound’s value?
As with all currencies, there are many factors that move the Pound. Here are six things that have some of the greatest impact on the GBP.
The balance of payments (BoP) is an accounting record of a country’s economic relationship with the world. It's made up of three main accounts: the current account, the financial account, and the capital account.
The current account mostly affects how a country’s currency performs on the market and greatly interests forex traders. It shows the flow of income, the quantities a country is importing and exporting, and its transfer of payments.
A current account surplus indicates that more capital is flowing into the country, and this positively influences the currency. It makes investors more confident about the economy, helping the currency appreciate.
When a country has a current account deficit, there’s more money going out because it’s spending more on foreign goods. The size of the deficit determines the impact on the currency value. The UK releases its current account report quarterly.
The current account balance for Q3 2020 was £15,734 million. Exports grew by £21.4 billion while imports rose by £17.5 billion. The total trade surplus increased to £6.9 billion after inflation was factored in.
The political stability of the nation issuing a currency has a huge effect on its value. If investors expect a country’s government to undergo significant change, they are less likely to demand its currency.
In 2014, during the referendum on Scottish independence, there was significant volatility in the GBP/USD currency pair. The currency hit a short-term low but recovered quickly. Scotland expected a second referendum in 2020, but paused the plans because of the coronavirus crisis.
Brexit also affected the British Pound significantly. In 2016, the Pound performed poorly against the US dollar and euro immediately after the British referendum to leave the EU. The currency fell again after the re-election of Jeremy Corbyn.
The Pound recovered slightly in 2017, but sank again with the possibility of a no-deal Brexit looming. The situation became worse in May 2019 when Minister Theresa May resigned. By August 2019, the UK currency had hit a 10-year low against the euro.
The uncertainties surrounding Brexit increased the volatility of the Pound. But after a Brexit deal was reached, the Pound recovered some certainty and has remained relatively stable.
Economic conditions affect the currency value. Generally, countries with high inflation levels see a depreciation in their currency value compared to other countries. This is because consumers have lower purchasing power.
High inflation usually causes the central bank to raise short-term interest rates to lessen the inflation effects and stabilize the price level. Low inflation boosts the currency value because the country’s purchasing power increases. This leads to increased global demand for that currency.
Consumer prices distinctly affect the level of a country’s inflation. 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 government's inflation target sets the price stability objective. It is 2% annual growth in Retail Prices Index excluding mortgages (RPI-X). If inflation is 2%, prices are 2% higher than they were the previous year. The Bank of England adjusts inflation to meet the 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 Pound. A high inflation rate in the UK may lead to higher retail prices as the Bank of England adjusts rates to match the inflation. The 2.1% rise in inflation that occurred in July 2019 was the highest in almost two years.
The Bank of England also uses the Producer Price Index (PPI) as an inflation indicator. The report shows how changes in inflation affect raw materials, in turn affecting consumer prices.
In any country, the Central bank policy influences the exchange rates. The Bank of England controls interest rates and money supply, which can devalue or inflate the Pound sterling.
The Bank of England Act of June 1997 gave the bank operational independence to set monetary policies and deliver price stability. The monetary policy executed by the bank is crucial to promoting monetary stability and supporting the government’s growth.
The policy keeps inflation low and builds confidence in the currency. When inflation threatens the stability of the pound, the bank uses monetary policy tools to control it. This 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 Monetary Policy Committee (MPC) determines the monthly bank interest rates. Policy changes also affect the exchange rates directly, especially the British Pound currency pairs. These include GBP/EUR, GBP/USD, and GBP/CAD.
Of these three, financial experts consider the GBP/USD to be the most liquid currency pair. 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.
Countries with strong economies have strong currencies because other countries invest in those economies. Since they need local currency to invest, demand goes up and boosts the money's worth.
The United Kingdom uses GDP as the primary measure for the overall level of economic activity. Because of this, GDP can significantly alter currency values. There are three GDP reports that affect the Pound’s trading capacity. These are the Preliminary GDP, the Revised GDP, and the Final GDP.
The Preliminary GDP usually has the biggest impact. It is released earlier and provides a glimpse into the UK’s economic health. 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 Manufacturing and Services Purchasing Managers' Index (PMI). Retail sales have a larger importance because consumers are the drivers of economic activity.
Monitoring the sentiment and confidence in the market is important because it helps determine how optimistic or pessimistic people are about the economy. Reports that gauge market sentiment highlight changing economy trends which can affect the Pound’s value.
To detect shifting trends, traders analyze whether the majority of the people are optimistic or pessimistic. Changes in pessimism or optimism and the magnitude of those changes directly affect the British pound.
The Nationwide Consumer Confidence Index and GfK Consumer Confidence are surveys that provide a snapshot of the economic environment. They contain five questions about employment, the general economic environment, and future expectations. The reports help traders forecast which way the UK economy is headed.
The key difference between these two reports is the time period assessed. The Nationwide Consumer Confidence Index gauges the respondents’ outlook on their current situation and their expectations for the next six months.
In contrast, 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. Both reports offer a useful way to assess sentiment towards the direction of the UK economy.
The state of UK politics in general and the Prime Minister in office determines how much confidence the population has in the economy.
There are many things that move the British Pound. Some directly affect the currency while others are based on speculations by traders and consumer behavior. What's sure is that changes happen quickly, and can be difficult to predict.
Do you plan to send Pounds in the future? Set a Rate Alert, and we’ll watch the markets for you and let you know when the rates are in your favour.