Tuesday was a particularly busy and volatile day for the pound US dollar exchange rate. With many influential events the exchange rate traded to a low of US$1.3342 and a high of US$1.3425 several times within 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 initially traded lower after UK labour report disappointed investors. The unemployment level remained constant at 4.2% as analyst expected. However average earnings unexpectedly dipped down to 2.8% in the three months to April, from 2.9% the month before. Whilst this was still above inflation in April, which was 2.4%, falling wage growth will give the Bank of England (BoE) fewer reasons to raise interest rates.
|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.|
The pound surged later on, after UK Prime Minister Theresa May managed to win a key Brexit vote in Parliament. There were doubts as to whether May would actually be able to win the vote and it appears that she only avoided defeat after a late concession. May won with 324 votes versus 298.
The pound rallied for two reasons. Firstly, Theresa May has managed to cling onto power. Defeat in this vote would have been a challenge on her authority and would have almost certainly ended with Theresa May being kicked out as Prime Minister.
Secondly the pound rallied because in order to win the vote May had to agree to hand more control over Brexit to MP’s. MP’s will now have increased power should May fail to secure a Brexit deal. This will make a softer Brexit divorce more likely. Any sign of a softer Brexit is favourable to 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 investors will look towards UK inflation numbers. A soft reading could pull the pound lower.
The dollar started the previous session on the front foot following an upbeat historic meeting between President Trump and North Korea’s Kim Jong Un. Trump had set the bar quite low for the meeting so the fact that it went well boosted general market sentiment, lifting the dollar.
Strong economic data also supported the dollar in the afternoon. Inflation in the US, as measured by Consumer Price Index increased ahead of analysts’ expectations at 2.8% in May, its fastest pace in 6 years, up from 2.5% in April. Meanwhile core inflation matched analyst forecasts at 2.2%. Higher inflation makes a rate rise from the Fed more probable and so lifted the dollar.
US dollar traders will now look ahead to the Fed rate decision. The Fed are expected to hike interest rates.
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.