The pound charged higher yesterday versus the euro as UK inflation hit the highest level in four years and investors look ahead to see how wages are faring in comparison.
The pound euro exchange rate jumped 0.7% to a high of €1.1389, regaining ground lost following the UK general election where the UK Conservatives won with a minority rule. Despite the rally, the pound is still 1.3% lower against the euro compared to before the UK election, which means political tension will continue to weigh.
|What do these figures mean?
When measuring the value of a pair of currencies, one set equals 1 unit and the other shows the current equivalent. As the market moves, the amount will vary from minute to minute.
For example, it could be written: 1 GBP = 1.13990 EUR
Here, £1 is equivalent to approximately €1.14. This specifically measures the pound’s worth against the euro. If the euro amount increases in this pairing, it’s positive for the pound.
Or, if you were looking at it the other way around: 1 EUR = 0.87271 GBP
In this example, €1 is equivalent to approximately £0.87. This measures the euro’s worth versus the British pound. If the sterling number gets larger, it’s good news for the euro.
Inflation in Britain increased quicker than analysts had expected at 2.9%. The Brexit-weakened pound means that imported goods are more expensive. This is what is pushing up inflation. To put the figure into perspective, inflation just prior to the Brexit referendum last year was only 0.3%. Usually, when inflation moves higher, particularly above the central bank’s target (2% in the case of the Bank of England), a central bank will look to increase interest rates. As interest rate expectations increase, the value of the currency increases which is why the pound rallied.
|Why do raised interest rates boost a currency’s value?
|Interest rates are key to understanding exchange rate movements. Those who have large sums of money to invest want the highest return on their investments. Higher interest rate environments tend to offer higher yields. So, if the interest rate or at least the interest rate expectation of a country is relatively higher compared to another, then it attracts more foreign capital investment. Large corporations and investors need local currency to invest. More local currency used then boosts the demand of that currency, pushing the value higher.
It’s worth noting that the Bank of England (BoE) previously said that they’re willing to look through the current spike in inflation. In other words, they aren’t looking to raise rates despite the pound-induced inflation. The BoE is due to meet on Thursday and investors will watch closely to see if the central bank is still willing to look through almost 3% inflation.
Whilst UK inflation continues to tick higher, all eyes will be on the UK wage data today. Bloomberg analysts are expecting UK annual earnings to increase at a rate of 2.4%. The figure is lower than inflation of 2.9%. Meaning the UK worker is actually experiencing a fall in wages. This could be detrimental to the economy should households rein in spending as they feel their purse being pinched. Should UK wage data come in lower than expected, the pound could tumble as fears would grow over the state of the UK economy.
|Why does strong economic data boost a country’s currency?
|Solid economic indicators point to a strong economy. Strong economies have strong currencies because institutions look to invest in countries where growth prospects are high. These institutions require local currency to invest in the country, thus increasing demand and pushing up the money’s worth. So, when a country or region has good economic news, the value of the currency tends to rise.
There hasn’t been much going on in the eurozone to attract the attention of investors. Today we could see interest in the euro pick up slightly ahead of German inflation data. Inflation in Germany, as well as the eurozone in general has been sluggish. The European Central Bank is keen for inflation to tick up towards the target level of 2% before any monetary policy tightening begins. Analysts expect a reading of 1.5% from Germany, so any figure above 1.5% could strengthen the euro against a fragile pound.
This article was initially published on TransferWise.com from the same author. The content at Currency Live is the sole opinion of the authors and in no way reflects the views of TransferWise Inc.