After a busy Wednesday, today’s session looks rather calm in comparison. The pound rallied strongly versus the dollar in the previous session. A strong UK jobs report and a more conservative U.S. Federal Reserve Chair, pushed the pound-dollar exchange rate to a day’s high of $1.2908.
|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 = 1.28934 USD
Here, £1 is equivalent to approximately $1.29. This specifically measures the pound’s worth against the dollar. If the U.S. dollar amount increases in this pairing, it’s positive for the pound.
Or, if you were looking at it the other way around: 1 USD = 0.77786 GBP
In this example, $1 is equivalent to approximately £0.78. This measures the U.S. dollar’s worth versus the British pound. If the sterling number gets larger, it’s good news for the dollar.
Wages grew in the three months to May at 2%, beating expectations of 1.9%, and up slightly from the 1.7% reading the previous month. The 2% figure is good news in itself, but when inflation is pulled into the equation at 2.9% in May, wages are still a long way behind the cost of living. Unfortunately, this spells bad news for the consumer and for the UK economy which is so dependant on consumer spending.
Other areas of optimism in the UK jobs report came from unemployment hitting a 43 year low after it unexpectedly ticked down to 4.5% and the employment rate reached a fresh all-time high at 74.9%. Finally, jobless claimants beat expectations at just 6,000 compared to the 10,000 analysts had forecast.
Today’s figures point to a tightening in the labour market. As the labour market tightens wages will usually then push higher. And as wage growth is a lagging indicator the expectation is that wages are now set to increase.
Higher wages mean higher inflationary pressures and usually lead to a rise in interest rates by the central bank. Higher interest rate expectations tend to push a currency higher, which is what happened to sterling.
|How does strong jobs data boost the currency?
|It works like this, when there is low unemployment and high job creation, the demand for workers increases. As demand for workers goes up, wages for those workers also go up. Which means the workers are now taking home more money to spend on cars, houses or in the shops. As a result, demand for goods and services also increase, pushing the prices of the good and services higher. That’s also known as inflation. When inflation moves higher, central banks are more likely to raise interest rates, which then pushes the worth of the currency higher.
The economic calendar for the UK is now quiet for the remainder of the week. With this in mind the dollar could take a more dominant role in the direction of the GBP-USD exchange rate.
The dollar was out of favour in the previous session after Federal Reserve Chair Janet Yellen unexpectedly sounded more conservative in her semi-annual testimony before Congress. She confirmed that gradual rate hikes will be required over the next few years but also said that rates won’t have to rise much further to go neutral. Once more Yellen clearly stated that everything hinged on inflation, which remains uncertain and is still below the central bank’s 2% target, after dropping recently.
These are not comments made by a central banker keen to hike rates and a September rate rise is now almost completely off the table. The probability of a December rate rise is still at just 50%. When interest rate expectations dip, so does the value of the currency, which is why the dollar sold off.
|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.
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.