The pound extended its gains against the dollar in the previous session. The pound US dollar exchange rate hit a high of US$1.3820, as it continues to trade at its highest level since the Brexit referendum in June 2016.
|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 continued to drive higher on Monday, adding to gains from last week. News at the end of last week that the Spanish and Dutch finance ministers were wanting to push for a close relationship between the UK and the EU post Brexit, boosted the pound. Market participants are hopeful that this could mean that there is an increased likelihood of a “soft Brexit” for Britain when it leaves the European Union. A soft Brexit would be the best and least disruptive type of Brexit for the UK and therefore for the pound.
|Why is a “soft” Brexit better for sterling than a “hard” Brexit?
|A soft Brexit implies anything less than UK’s complete withdrawal from the EU. For example, it could mean the UK retains some form of membership to the European Union single market in exchange for some free movement of people, i.e. immigration. This is considered more positive than a “hard” Brexit, which is a full severance from the EU. The reason “soft” is considered more pound-friendly is because the economic impact would be lower. If there is less negative impact on the economy, foreign investors will continue to invest in the UK. As investment requires local currency, this increased demand for the pound then boosts its value.
Today sterling traders will turn their attention once again to economic data. UK inflation figures are due to be released today and could set the tone for the pound for the rest of the week. Analysts are anticipating that inflation will have ticked down marginally in December to 3% from 3.1% in November. This figure still remains significantly above the Bank of England’s target rate for inflation of 2%. Should the figure be higher than that expected by analysts, the pound could rally even higher. This is because high rates of inflation increase the chances of a central bank raising interest rates, in order to bring inflation back under control.
|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.
Sentiment towards the dollar continues to be lacklustre and the greenback is unable to recover ground. The dollar has fallen for four straight sessions, with the slide gaining momentum in the last two sessions.
Growing optimism surround the global economy is actually working against the dollar. Whilst the US Federal Reserve is looking to raise interest rates in 2018, other central banks are also making noises that they too could raise interest rates in 2018. This would mean that the differences in interest rates with other currencies would flatten out and make the dollar less attractive that it was.
Today is another very quiet day for US economic data. The only US release is a low impacting manufacturing reading. However, should the reading beat expectations, it could help to ease the heavy selloff in the dollar.
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.