Pound vs. Dollar To Rise After UK Inflation Data Despite Monday's Sell-off?

Political uncertainty in the UK pushed the pound US dollar exchange rate sharply lower on Monday. The pound dropped from a session high of US$1.3180 to a low of US$1.3062. However, the pound US dollar exchange rate picked up from this low while moving towards the end of the session.

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 US 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 US dollar’s worth versus the British pound. If the sterling number gets larger, it’s good news for the dollar.

The pound tumbled on Monday as investors grew increasingly nervous as to whether UK Prime Minister Theresa May was going to be able to hold onto her power. It was reported that members of Theresa May’s own Conservative party expressed a lack of confidence in her ability to run a government and the country. So far there are 40 MP’S that are ready to sign a letter of no-confidence.However, it is also fairly clear that there is no obvious alternative leader waiting in the wings of the party. Removing Theresa May could lead to a politic uncertainty over the leadership of the country, which at this stage in the Brexit negotiations would be disastrous. The mere possibility of this sent the pound lower.

How does political stability boost a currency?
Political stability boosts both consumer and business confidence, which means corporations and regular households alike are more likely to spend money. The increased spending, in turn, then boosts the economy. Foreign investors prefer to invest their money in politically stable countries as well as those with strong economies. For foreign investors to put their money into an economy, they need local currency. As they acquire the money needed, the demand for that particular currency increases, which then boosts its value.

While investors will continue to watch developments in Westminster, UK inflation data will also attract some attention. Analysts are forecasting that UK inflation, as measured by the consumer price index (CPI) will hit 3.1% in October, up from 3% in September. The CPI simply measures changes in the prices of consumer goods and services purchased by households. The Bank of England (BoE) recently raised interest rates in order to try to bring inflation back towards the central bank’s 2% target level. A high reading today could inspire a rally in the pound as it could boost investor’s expectations of another interest rate hike from the BoE in the near future.

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.

Investors Look to US Fed Chair Yellen

The mood towards the dollar remained positive in the previous session despite hopes fading that Trump’s tax reform will make it through before the end of the year.

The US continues to produce robust economic data, pointing to a resilient US economy. As a result, the US Federal Reserve remains set to hike interest rates at the last Fed monetary policy meeting in December. This will be US Federal Reserve Chair Janet Yellen’s last policy meeting as Chair before Jerome Powell takes over in February.

Yellen is due to speak today at the 20th Euro Finance Week in Frankfurt. If she speaks on the subject of monetary policy, analysts are not expecting her to deviate from existing stance on this matter that she recently communicated. In short, no surprises are expected. If Yellen sounds positive regarding the outlook of the US economy, the dollar could rally.

This publication is provided for general information purposes only and is not intended to cover every aspect of the topics with which it deals. It is not intended to amount to advice on which you should rely. You must obtain professional or specialist advice before taking, or refraining from, any action on the basis of the content in this publication. The information in this publication does not constitute legal, tax or other professional advice from TransferWise Inc., Currency Live or its affiliates. Prior results do not guarantee a similar outcome. We make no representations, warranties or guarantees, whether express or implied, that the content in the publication is accurate, complete or up to date. Consult our risk warning page for more details.

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.