The British pound (GBP) - Main features

The British pound (symbol: £, ISO code: GBP), commonly referred to as the pound, is the United Kingdom's official currency.

It is the foreign exchange market's 4th most traded currency following the US dollar, the euro and the Japanese yen.

It is also the 3rd largest reserve currency in world reserves (about 4%).

The Bank of England is the central bank for the British pound. It issues its own notes and coins and regulates the issuance of bank notes by private banks in both Scotland and Northern Ireland.

The British pound: an introduction

The British pound occupies an important place in economic history, having already been the world's dominant currency at one time and now occupying the position previously held by the US dollar in terms of importance in both international trade and accounting. Given the economic consequences of World War II and the collapse of the UK's world empire, the pound lost its prominence in the 1940s, but it certainly did not lose its relevance.

The pound also has an interesting place in the history of hedge funds and forex speculation. Britain joined Europe's exchange rate mechanism (ERM) in 1990, a "semi-fixed" exchange rate system that aimed to ease some of the volatility of exchange rates and pave the way for a single currency. Unfortunately, the system did not produce the expected benefits and Britain experienced recessionary pressures and large capital outflows from the Bank of England in a vain effort to maintain the established exchange rate.

Currency traders, led by trader George Soros, bet that this rate could not be maintained (economic conditions had made it unsustainable) by aggressively trading against the British pound. When Britain eventually withdrew from the system (on Wednesday 16 September 1992, known as "Black Wednesday"), Soros made over a billion dollars in profits thanks to his trades.

All of the foreign exchange market's major currencies have central banks behind them, and the British pound is administered by the Bank of England. Although almost all Western central banks consider inflation control to be the top priority (with the promotion of a certain level of economic growth), the Bank of England has explicitly followed an inflation policy whose target is 2%.

Profile of Britain's economy

The United Kingdom is the world's 6th largest economy, with a GDP of $2,828 billion in 2018. The country also has one of the world's most efficient central banks and its economy has grown steadily for many years and features a low unemployment rate, as well as positive production growthand a level of consumption that is generally resistant to economic problems. Much of the strength in consumption is attributable to the UK's strong housing market, which accelerated in 2003, although in recent years it has declined due to the global economic crisis.

The country's economy is now service-oriented. As such, manufacturing activities now account for a declining share of GDP (one-fifth of national output). Its capital systems are among the most developed and, as a result, its banking and financial activities have become the greatest contributors to national GDP. Although most of the UK's GDP comes from the services sector, it is also important to keep in mind that it is one of the EU's largest producers and exporters of natural gas. The energy-producing industrial sector accounts for 10% of the country's GDP, one of the highest proportions among industrialised countries. This is important because rising commodity prices in the energy sector (such as oil) have a positive and significant impact on British oil exports.

Overall, though, the United Kingdom imports more goods than it exports and has a constant trade deficit. The UK's main trading partner is the European Union, with over 50% of commercial activities. However, at the individual level, the United States is still the country's most important trading partner.

• Main export markets: United States, Germany, France, Holland and Ireland.
• Main import markets: United States, Germany, France, Holland and Belgium.

To date, the UK government has demonstrated that it is able to implement sound macroeconomic policies that work well for the country. In fact, the UK's monetary and fiscal policies have allowed it to outperform most of the other EU economic powers, even in times of uncertainty in the global economy.

Agencies in charge of regulating monetary policy in the United Kingdom

The United Kingdom's central bank is the Bank of England (BoE), which regulates the country's monetary and fiscal policy. The Monetary Policy Committee (MPC) is a nine-member body responsible for defining the nation's monetary policy, consisting of a chairman, two vice-chairmen, two executive directors of the BoE and four external experts. Since 1997, it has enjoyed full operational independence in the determination of monetary policy. Its policies have focused on achieving the above-mentioned 2% inflation target.

The Bank of England has the power to change interest rates to the levels it deems appropriate to achieve this objective. The MPC holds monthly meetings that are closely monitored, especially when there is an announcement of significant changes in the country's monetary policy, such as a change in interest rates.

After each meeting, the MPC issues statements as well as a quarterly report on inflation, detailing growth and inflation projections for the next two years and the rationale for changes to its policies.

It also publishes another newsletter, the quarterly bulletin, which provides information on past changes in monetary policy and an analysis of the international economic scenario and its effects on the UK economy. All of these reports provide fairly detailed information on MPC policies and their future preferences for monetary policy. The main tools used by the Bank of England and the MPC to implement their policies are:

Open market transactions

The purpose of the BoE's free market transactions is to implement changes in the repo bank rate (refinancing rate), as well as to ensure an adequate level of liquidity in the market and the stability of the banking system. This reflects the Bank of England's main objectives:

• Maintaining the value and integrity of the British pound.
• Maintaining the stability of the financial system.
• Ensuring the stability and efficiency of the UK's financial services.

In order to ensure liquidity, the BoE trades daily in the open market, buying and selling short-term government fixed income securities. If these transactions are not sufficient to meet liquidity requirements, the BoE may enter into additional overnight transactions.

The key rate or refinancing rate

In the UK, this is the most important interest rate used in monetary policy to achieve the inflation target. It is set for the Bank of England's own market transactions, such as short-term lending activities. Changes in this interest rate affect the rates set by commercial banks for both borrowers and savers, and at the same time have a direct impact on the output of the economy and expenditures, and ultimately on prices and costs. When this rate is high, it means that the BoE and the MPC are probably trying to combat inflation, while a decline in inflation implies a stimulus for the country's economic growth and expansion.

Main features of the British pound

The GBP has three names: the British currency has three names that are used as synonyms: the British pound, the pound sterling and the cable.

The GBP/USD currency pair has a high level of liquidity: the GBP/USD is one of the world's most liquid pairs. Currently, around 6% of all foreign currency transactions have the British pound as their base currency or counterparty currency. It is one of the forex's 4 most liquid currency pairs, along with the EUR/USD, USD/JPY and USD/CHF. One of the reasons for this high liquidity is the extensive development of capital markets in the UK. Many foreign investors, who have traditionally invested their money in the United States, have transferred their funds to the UK, and in order to invest, foreigners have to convert their local currency into British pounds.

Many speculators regularly trade the pound sterling: until recently, the pound sterling had one of the highest interest rates among developed countries' currencies. Although Australia and New Zealand have higher interest rates, their financial markets are not as developed as those of the UK. As a result, many traders who held positions or had an interest in opening new carry trade positions frequently used the British pound as their investment currency and opened long positions in British pounds versus currencies such as the US dollar, the Swiss franc and the Japanese yen, which have lower interest rates. However, as the pound's interest rates are even lower than those of the dollar (0.75 versus 2.50 in January 2019), this is no longer the case. Carry trading involves buying or borrowing a currency with a higher interest rate and selling or borrowing a currency that has a lower interest rate. In recent years, the popularity of this type of transaction has increased, which has helped boost demand for British pounds. However, as the interest rate spread between the British pound and other currencies has narrowed, the British pound's volatility has increased due to the exodus of traders seeking to invest their money in higher yielding investments. Despite this, GBP currency pairs, especially the GBP/USD, are very popular with speculators because of the high volatility they offer, which can reach over 100 pips per day. Several factors contribute to the British pound's volatility, which we will discuss further below.

The British pound "crosses" itself: although the GBP/USD is more liquid than the EUR/GBP, the latter pair is usually the main indicator of the British pound's strength. The GBP/USD tends to be more sensitive to events in the United States, while the EUR/GBP is fundamentally considered to be a British pound transaction, as the EU is the UK's largest trading partner. However, the two currencies are naturally interdependent, which means that movements of the EUR/GBP can affect the GBP/USD. The opposite can also happen. Therefore, it is important that traders who trade the British pound monitor the market behaviour of both currency pairs. The EUR/GBP's exchange rate must be equal to the EUR/USD's exchange rate divided by the GBP/USD's rate. The small differences between them are exploited by the various market players and disappear shortly after they appear.

The British pound has a positive correlation with energy commodity prices: the United Kingdom is home to some of the world's largest energy companies, such as British Petroleum. Energy production accounts for around 10% of the UK's GDP and the pound therefore tends to have a positive correlation with energy commodity prices. More specifically, since several members of the European Union import oil from the United Kingdom, when crude oil prices rise, they have to buy more pounds in order to buy energy. Moreover, the higher the price of oil, the higher the profits of the country's energy exporters.

EUR/GBP futures offer signals regarding possible interest rate movements: as the UK interest rate or repo rate is the UK's main monetary policy instrument, investors need to monitor potential variations in this interest rate. However, the BoE is one of the few central banks to require members of its Monetary Policy Committee to make public the results of their votes in this regard. The purpose of this is to show that the comments of each member of the committee represent their own personal opinions and not those of the Energy Committee; it is therefore also necessary to analyse other indicators of possible interest rate changes by the Commission. The 3-month standardised euro and British pound futures contracts reflect the market's expectations regarding the 3-month interest rates. In general, these contracts are also useful for predicting the evolution of the UK's interest rates, which ultimately affects GBP/USD price movements.

Interest rate differentials between British Treasury bills (gilts) and foreign bonds are at the heart of the market's attention: forex traders generally closely follow interest rate spreads between British and German treasury bills, as well as spreads between UK bonds and US debt. The latter can serve as an important indicator of GBP/USD flows, while the former serve as indicators of EUR/GBP flows. Specifically, interest rate spreads indicate the performance of UK fixed income assets relative to US and European fixed income assets and vice versa. The German bund is generally used to measure European performance. These spreads provide traders with signals of potential capital flows or possible currency movements as global investors always move their capital in search of assets that offer higher returns. Currently, the UK offers these returns while maintaining the same credit stability as the United States.

The political and economic events related to the UK and politicians' comments can have a strong effect on the British pound: this is categorically obvious with the Brexit and all of the events and news related to this event. Many factors influence currency prices, but Brexit, for example, was key to the low pound that was observed in 2019. In the aftermath of the June 2016 European referendum, the British pound had fallen over 10% against the dollar and over 7% against the euro, and it still hasn't recovered. If there's one thing that the experts agree on, it's that it's impossible to predict how the exchange rates will behave in the coming months and years.

The factors that influence the British pound's price

The economic models designed to calculate the "right" currency exchange rates are notoriously inaccurate relative to genuine market exchange rates, in part because economic models are usually based on a very small number of economic variables (sometimes only one variable), such as interest rates). However, investors and traders are incorporating a much wider range of economic data into their investment decisions, and their speculative outlook may cause prices to fluctuate in the same way that investor optimism or pessimism can change a stock's price (above or below the value suggested by its fundamentals).

The most significant economic data includes the publication of GDP, retail sales data, industrial production and inflation figures and the trade balance. This data is published at regular intervals and many brokers, as well as many sources of financial information such as the Wall Street Journal and Bloomberg, make this information available free of charge. Investors should also take note of information on employment, interest rates (including planned central bank meetings) and the day's news: natural disasters, elections and new government policies can have a major impact on exchange rates.

With its stated policy of keeping inflation around 2%, the Bank of England's interest rate announcements (and commentaries on it) are extremely important. Traders also monitor key commodities such as oil, natural gas and grains to identify possible inflationary pressures.

Britain is also an important destination for global investments, and such capital flows can certainly influence exchange rates. Britain has increasingly become the preferred alternative destination to New York for large capital investments, and this activity influences the currency. Carry trade isn't as important a factor for the British pound.

Unique factors specific to the British pound

The British pound, the world's 3rd most widely held reserve currency, plays an important role that seems a little over-sized in relation to its economic rank in the world. This may be partly due to the country's status as a financial trading hub and financial capital of Europe, but also partly because of the country's long history of global leadership.

The United Kingdom also enjoys a somewhat volatile reputation as a relatively conservative economy that is carefully managed. While this perception certainly fluctuates depending on which party governs the country (and to what extent these policies promote or reduce public spending and transfer payments), most observers agree that the UK focuses on prudent and conservative policies aimed at steady (but not ambitious) growth. It should also be noted that the British pound is one of the few currencies that is worth more than the US dollar (which means that 1 British pound buys more than 1 dollar).

The British pound on the forex market

The British pound is one of the world's most traded currencies, accounting for around 13% of daily forex trading volume.

The most commonly traded British pound currency pairs are with the US dollar (GBP/USD) and the euro (EUR/USD). The GBP/USD currency pair, known as "the cable" by traders, is the pound's most traded currency pair.

Due to their size and importance, the main GBP currency pairs are the:

• GBP/USD
• EUR/GBP
• GBP/JPY
• GBP/CHF
• GBP/AUD
• GBP/NZD
• GBP/CAD

However, the British pound is also traded against a large number of currencies, including exotic currencies such as the Mexican peso (GBP/MXN), the Norwegian kroner (GBP/NOK) and the South African rand (GBP/ZAR), among others.

Conclusions

Exchange rates are very difficult to predict and most models rarely work over long periods. Although economic models are rarely useful for short-term traders, economic conditions doindeed shape long-term trends.

Great Britain may be small in terms of its population, but it is a major world economy with a lengthy and rich history of global economic leadership. It appears as though the UK has struck an ideal economic balance between manufacturing and services, while pursuing policies based on both stability and predictability. As a strong alternative to the dollar, the pound will likely continue to remain a preeminent world currency for a long time.

However, major geopolitical events (such as 2019's Brexit) could undermine the position of the pound, which long-term investors will have to take into account. For short-term traders, however, the volatility that events such as Brexit bring to the British pound market provide them with multiple trading opportunities.