British Pound Basics

The pound sterling, also known as the British pound, is the official currency of both the U.K. and its territories. It’s also the world’s oldest continuously used currency.1)Retrieved 19 December 2015 http://news.bbc.co.uk/2/hi/programmes/bbc_parliament/7090665.stm Traded under the currency code GBP and carrying the symbol £, the pound also goes by the name quid and is divided into 100 pence.

The pound sterling derives its name from ancient history, as in roughly 775 A.D. silver coins called sterlings were issued in the Saxon kingdoms. At the time, one pound of silver, which had a weight likely equal to that of a troy pound, yielded 240 of these coins.2)Retrieved 19 December 2015 http://www.britannica.com/topic/pound-sterling

Because of this decision to mint coins based on pounds of silver, market participants ended up measuring large payments in “pounds of sterlings.” Later on, users of this form of currency slimmed it down to “pounds sterling.”

Causes Of Volatility

The following are the causes of volatility in the British pound:

Central Bank Policy
Central bank policy is often cited as a factor that impacts exchange rates. These financial institutions can help devalue or inflate the currencies used by their jurisdictions through controlling the money supply, interest rates and inflation.

In some cases, central banks take a more direct role in the currency markets by using their foreign exchange reserves to ensure that their domestic currency continues to trade on a certain level relative to other currencies. For example, the Bank of China pegged the dollar to the renminbi in 1994.3)Retrieved 19 December 2015 http://blogs.ft.com/the-exchange/2015/08/15/12598/

There are several British pound currency pairs, including GBP/USD, GBP/CAD and GBP/EUR. Of these, many consider GBP/USD in particular to be a highly liquid currency pair.

By looking at the policies used by the Bank of England and the Federal Reserve Bank, we can illustrate how the actions of such financial institutions can affect exchange rates. Should the policies of these two organisations diverge, this development could impact GBP/USD.

In December 2015, the Fed announced it was raising interest rates for the first time since 2006.4)Retrieved 19 December 2015 http://www.telegraph.co.uk/finance/economics/12058664/The-Fed-has-acted-now-it-is-the-Bank-of-Englands-turn.html Many market observers were watching for this move, as the financial institution ended its latest round of bond purchases in 2014.

After this decision was announced, the BOE did not specify plans to follow suit and hike its interest rates. According to a report in The Telegraph released Dec. 18, 2015, BOE Governor Mark Carney as well as Minouche Shafik, his deputy governor, have provided communications that may indicate the nation’s central bank will not hike rates very soon. In the past, Carney emphasized that the BOE’s policy moves might not mirror those of the Fed.5)Retrieved 19 December 2015 http://www.theglobeandmail.com/report-on-business/international-business/european-business/fed-hike-clears-path-for-bank-of-england-but-not-right-away/article27869816/

What does this mean for the exchange rate? If the Fed continues to hike benchmark rates, this development will likely place upward pressure on broader interest rates in the nation. If the U.S. central bank takes this approach and the BOE refuses to push its benchmark rates higher, there will likely be an interest rate differential between the two countries.

If interest rates are higher in one country than another, the nation with the higher rates will probably provide lenders with stronger returns. As a result, market participants may opt to invest their foreign capital into the country with higher interest rates, which would likely push that country’s currency higher.

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Economic Conditions
Economic conditions can potentially affect exchange rates. For example, if a nation experiences high inflation, its currency can encounter downward pressure because of reduced purchasing power. However, it is worth keeping in mind that if a country does encounter high inflation, the jurisdiction’s central bank may hike short-term interest rates in an effort to keep the price level from rising too quickly.

In contrast, if a country has low inflation, its currency could track higher as its purchasing power increases. This could bolster global demand for that particular currency.
Current Account Deficit
Another factor that could impact the value of the British pound relative to other currencies is the size of the nation’s current account deficit. A country’s current account is the balance of trade between a nation and its trading partners.

If a country incurs a current account deficit, it is spending more on foreign goods than it is bringing in. To make up for this shortfall, a nation in this position must borrow capital from foreign sources. The U.K. current account deficit hit £97.9 billion in 2014, and this figure was equal to 5.5% of GDP, the largest fraction since the nation’s government started collecting these figures in 1948.6)Retrieved 20 December 2015 http://www.ons.gov.uk/ons/dcp171778_400416.pdf The Bank of England’s Financial Policy Committee warned during its March 2015 meeting that the country’s current account deficit could present a risk to the market’s perception of the U.K.7)Retrieved 20 December 2015 http://www.bankofengland.co.uk/publications/Documents/records/fpc/pdf/2015/record1504.pdf If the nation’s current account deficit remains high, investors may be more likely to shun the pound in favour of other currencies.
Market Psychology
Market psychology can have a major impact on fluctuations in currencies such as the British pound. For example, when investors are relatively optimistic about economic conditions, they may opt to purchase riskier currencies in hopes of enjoying stronger returns.

However, if traders are pessimistic about business conditions, they may flock to currencies that are generally considered safe to protect their principal. By doing so, these investors may risk reducing their potential returns.

If the global markets consider the British pound relatively safe, they may be more likely to buy it when they are concerned about economic conditions.
Political Uncertainty
Political uncertainty is one more factor that can affect the value of the British pound relative to other currencies. When evaluating a currency, traders frequently consider the political stability of the nation that issues it.

If the governance of a country is at risk of undergoing substantial change, this situation could make investors less likely to demand its currency. An example of this is the Scotland vote, which considered Scotland’s potential succession from the U.K. Voters defeated the proposal, with 55% voting against the measure.8)Retrieved 20 December 2015 http://www.usnews.com/news/articles/2014/09/19/scotlands-secession-unsuccessful-as-voters-support-the-uk Leading up to the vote, GBP/USD experienced significant volatility, hitting short-term lows and then recovering.9)Retrieved 20 December 2015 https://www4.dailyfx.com/forex/fundamental/article/special_report/2014/09/17/british-pound-ahead-of-scotland-referendum.html

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