Currency Profile: British Pound (GBP)

Broad Economic Overview

The United Kingdom is the world's fifth largest economy with GDP valued at approximately US$3 trillion in 2014 according to the IMF. With one of the most dynamic central banks in the world, the UK economy benefited from many years of strong growth, low unemployment, expanding output, and resilient consumption. The strength of consumer consumption has been largely due to the strong housing market. The United Kingdom is a service-oriented economy, with manufacturing representing an increasingly smaller portion of GDP, now equivalent to only one-fifth of national output. Their capital market system is one of the most developed in the world, with finance and banking being the strongest contributors to GDP. Although the majority of the UK's GDP is from services, it is also one of the largest producers and exporters of natural gas in the European Union. The energy production industry accounts for 10% of GDP, which is one of the highest shares of any industrialized nation. This is particularly important, as increases in energy prices (such as oil) will significantly benefit the large number of UK oil exporters. (The United Kingdom became a net oil importer for a brief period due to disruptions in the North Sea in 2003, but it has already resumed its status as a net oil exporter.)

Overall, the United Kingdom is a net importer of goods with a consistent trade deficit. Its largest trading partner is the EU, with trade between the two constituencies accounting for over 50% of all of the country's import and export activities. The United States, on an individual basis, still remains the United Kingdom's largest trading partner. The breakdowns of the most important trading partners for the United Kingdom are the following:

Leading Export Markets

United States
Germany
Switzerland
Netherlands
France

Leading Import Sources

Germany
Netherlands
China
United States
France

Since the launch of the euro in 1999, the single currency's troubles have become increasingly apparent, and this has made the UK's decision to maintain its own currency and monetary authority increasingly intelligent. Yet the possibility of euro adoption will remain a question in the minds of pound traders for many years to come, although in 2015 into 2016, the more relevant question is whether the United Kingdom will remain in the EMU. A decision on euro entry has significant ramifications for the UK economy—the most important of which is that UK interest rates would have to be adjusted to reflect the equivalent interest rate of the Eurozone. One of the primary arguments against adopting the euro is that the UK government has sound macroeconomic policies that have worked very well for the country for decades. Its successful monetary and fiscal policies have led it to outperform most major economies during economic downturns, including the European Union.

The UK Treasury has previously specified five economic tests that must be met prior to euro entry, which are the following:

UK's Five Economic Tests for Euro

Is there sustainable convergence in business cycles and economic structures between the United Kingdom and other EMU members, so that the UK citizens could live comfortably with euro interest rates on a permanent basis?
Is there enough flexibility to cope with economic change?
Would joining the EMU create an environment that would encourage firms to invest in the United Kingdom?
Would joining the EMU have a positive impact on the competitiveness of the UK's financial services industry?
Would joining the EMU be good for promoting stability and growth in employment?

The United Kingdom is a very political country where government officials are highly concerned with voter approval. If voters do not support euro entry, the likelihood of EMU entry would decline. The following are some of the arguments for and against adopting the euro:

Arguments in Favor of Adopting the Euro

There would be reduced exchange rate uncertainty for UK businesses and lower exchange rate transaction costs or risks.
The prospect of sustained low inflation under the governance of the European Central Bank should reduce long-term interest rates and stimulate sustained economic growth.
Single currency promotes price transparency.
The integration of national financial markets of the EU will lead to higher efficiency in the allocation of capital in Europe.
The euro is the second most important reserve currency after the USD.
With the United Kingdom joining the euro, the political clout of the EMU would increase dramatically.

Arguments against Adopting the Euro

Currency unions have collapsed in the past.
Economic or political instabilities of one country would impact the Euro, which would have exchange rate ramifications for otherwise healthy countries.
Strict EMU criteria outlined by the Stability and Growth Pact.
Entry would mean a permanent transfer of domestic monetary authority to the European Central Bank.
Joining a currency union with no monetary flexibility would require the United Kingdom to have more flexibility in the labor and housing markets.
There are fears about which countries might dominate the ECB.
Adjusting to new currency will require large transaction costs.

Monetary and Fiscal Policy Makers— Bank of England

For the United Kingdom, the Bank of England (BoE) controls monetary policy, and the Monetary Policy Committee (MPC) is a nine-member committee responsible for setting interest rate policy in the United Kingdom. It consists of a governor, two deputy governors, two executive directors of the central bank, and four outside experts. The committee was granted operational independence in 1997, which means they won't be influenced by the governing party. Despite this independence, monetary policies have centered on achieving an inflation target dictated by the Chancellor of the Treasury. Currently, this target is RPIX (Retail Price Index) inflation of 2.5%. The central bank has the power to change interest rates to levels that will allow them to meet this target. The MPC holds monthly meetings, which are closely followed for announcements on changes in monetary policy, including changes in the interest rate (bank repo rate). When no changes are made, no details are provided. In this case, the rate decision is generally a nonevent for the currency, with traders shifting their focus to the minutes released two weeks later.

The MPC publishes statements after every meeting, along with a quarterly Inflation Report that details the MPC's two-year forecast for growth and inflation along with justification for policy movements. In addition, another publication, the Quarterly Bulletin, provides information on past monetary policy movements and analysis of the international economic environment and its impacts on the UK economy. All of these reports can provide guidance of future policy changes. The main policy tools used by the MPC and BoE are the following.

Important Characteristics of the British Pound

GBPUSD is very liquid. The GBPUSD is one of the most liquid currencies in the world, with 6% of all currency trading involving the British pound as either the base or counter currency. It is also one of the three most liquid currencies alongside EURUSD and USDJPY. One of the reasons for the currency's liquidity is the country's highly developed capital markets. Many foreign investors seeking opportunities other than the United States have sent their funds to the United Kingdom for investment. In order to create these transactions, foreigners will need to sell their local currency and buy British pounds.

GBP has three names. The UK's currency has three names: the British pound, sterling, and cable. All of these are used interchangeably.

GBP is laden with speculators. At the time of publication, the British pound has one of the highest interest rates among the developed nations. Although Australia and New Zealand have higher interest rates, their financial markets are not as developed as that of the United Kingdom. As a result, many investors who already have positions or are interested in initiating new carry trades positions frequently use the GBP as the lending currency and will go long the pound against currencies such as the U.S. dollar, Japanese yen, and Swiss franc. A carry trade involves buying or lending a currency with a higher interest and selling or borrowing a currency with a lower interest rate. In recent years, carry trades have increased in popularity, which helped spur demand for the British pound. However, should the interest rate yield differential between the pound and other currencies narrow, an exodus of carry traders will increase volatility in the British pound.

Interest rate differentials between Gilts and foreign bonds are closely followed. Interest rate differentials between UK Gilts—U.S. Treasuries and UK Gilts and German Bunds are widely watched by FX market participants. Gilts versus Treasuries can be a barometer of GBPUSD flows, while Gilts versus Bunds can be used as a barometer for EURGBP flows. More specifically, these interest rate differentials indicate how much premium yield UK fixed-income assets are offering over U.S. and European (German Bunds are usually used as a barometer for European yield) fixed-income assets, or vice versa. This differential provides traders with indications of potential capital flow or currency movements, as global investors are always shifting their capital in search of the assets with the highest yields. The United Kingdom can provide these yields with the safety of having the same credit stability as the United States.

Euro sterling futures can give indications for interest rate movements. Since the UK interest rate or bank repo rate is the primary tool used in monetary policy, it is important to keep abreast of potential changes to the interest rate. Comments from government officials is one way to gauge biases for potential rate changes, but the Bank of England is one of the only central banks that requires members of the Monetary Policy Committee to publish their specific voting records. This personal accountability indicates that comments by individual committee members represent their own opinions and not that of the BoE. Therefore, it is necessary to look for other indication of potential BoE rate movements. Three-month euro sterling futures reflect market expectations on euro sterling interest rates three months into the future. These contracts are also useful in predicting UK interest rate changes, which will ultimately affect the fluctuations of the GBPUSD. Figure 28.1 illustrates 10 year performance of GBP-USD.

Candlestick chart displaying the 10-year performance of GBPUSD from 2005 to 2015. — **Figure 28.1** GBPUSD 10-Year Chart

*Source*: eSignal

Comments on euro by UK politicians will impact the euro. Any speeches, remarks (especially from the Prime Minister or Treasury Chancellor), or polls in regards to the euro will impact currency trade. Indication of adoption of the euro tends to put downward pressure on GBP, while further opposition to euro entry will typically boost the GBP. Reason being that in order for the GBP to come in line with the euro, interest rates would have to decline and monetary policy would have to be subjected to a foreign entity. A decrease in the interest rate would induce carry trade investors to close their positions or sell pounds. The GBPUSD would also decline because of the uncertainties involved with Euro adoption. The UK economy is performing very well under the direction of its current monetary authority. The EMU is currently encountering many difficulties with member countries breaching EMU criteria. With one monetary authority dictating 19 countries (plus UK would be 20), the EMU has yet to prove that they have developed a monetary policy suitable for all member states.
GBP has positive correlation with energy prices. The UK houses some of the largest energy companies in the world, including British Petroleum. Energy production represents 10% of GDP. As a result, the British pound tends to have a positive correlation with energy prices. Specifically, since many members of the EU import oil from the United Kingdom, as oil prices increase, they will, in turn, have to buy more pounds to fund their energy purchases. In addition, rises in the price of oil will also benefit the earnings of the nations' energy exporters.
GBP crosses. Although the GBP/USD is a more liquid currency than EURGBP, EURGBP is typically the leading gauge for GBP strength. The GBPUSD currency pair tends to be more sensitive to U.S. developments, while EURGBP is a more pure fundamental pound trade since Europe is Britain's primary trade and investment partner. However, both currencies are naturally interdependent, which means movements in the EURGBP can affect movements in the GBPUSD. The reverse is also true—that is, movements in GBPUSD will also affect trading in EURGBP. Therefore, it is important for pound traders to be consciously aware of the trading behavior of both currency pairs. The EURGBP rate should be exactly equal to the EURUSD divided by the GBPUSD rate. Small differences in these rates are often exploited by market participants and quickly eliminated.

Chapter 28
Currency Profile: British Pound (GBP)

Broad Economic Overview

Monetary and Fiscal Policy Makers— Bank of England

Bank Repo Rate

Open Market Operations

Important Characteristics of the British Pound

Important Economic Indicators for the United Kingdom

PMIs

Employment Situation

Retail Sales

Consumer or Retail Price Index

GDP

Industrial Production

UK Housing Starts