Brexit fears and hopes of more interest rate hikes in the US sent the pound US dollar exchange rate diving on Wednesday. The pound dropped over 1.1% versus the dollar, taking the exchange rate to US$1.3750. This is the lowest that the pound has traded versus the dollar in 6 weeks.
|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 managed to hold its ground reasonably well in early trade, despite weak data. Data showed that UK Consumer confidence fell to -10 in February, down from -9 in January. Although falling consumer confidence is not good for the economy, the reading was in line with analysts expectations so the impact on the pound was minimal.
Brexit headlines caused the pound to plummet. Pound traders have been getting nervous over the lack of progress in Brexit talks, which have stalled once again over the Northern Ireland border issue. UK Prime Minister Theresa May, flatly rejected the only option covering the Irish border in the European Commission’s draft Article 60 Treaty. Here the EU proposes that Northern Ireland remains under EU rule, in order to prevent a hard border between Northern and Southern Ireland. The fact that there is considerable distance between the EU and the UK’s negotiating positions still and that there doesn’t appear to be a logical answer to the Irish border issue without discussing trade deals first, means negotiators could struggle to hit the deadline in three weeks’ time. Should no transition deal go ahead, the UK could be heading for a hard Brexit, which would be the worst-case scenario 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.|
The dollar continued to charge higher in the previous session, helped along by Fed Powell’s hawkish comments earlier in the week. The new Fed Chair expressed his optimism towards the US economy and hinted strongly towards raising interest rates more than the three times that his predecessor had planned. As investors adjusted their perceived odds of more rate hikes upwards, the value of the dollar rose.
|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.|
Even news that fourth quarter growth in the US economy was being revised down slightly to 2.5% from 2.6% was insufficient to pull the dollar down of its highs.
Today investors will be looking to US inflation data to see if markets fear of an increase in inflation are starting to play out. If inflation comes in higher then the dollar could rally 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.