The pound U.S. dollar exchange rate has been on a roller coaster ride over the past few days. A string of high impact economic data and central bank surprises, both in the U.S. and in the UK, have kept pound U.S dollar investors on their toes.
The pound reached a high of $1.2795 versus the dollar in the previous session, up from an earlier low of $1.2691 just prior to the Bank of England (BoE) announcement.
|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 U.S. 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 U.S. dollar’s worth versus the British pound. If the sterling number gets larger, it’s good news for the dollar.
The BoE Monetary Policy Committee (MPC) voted to in a shock split of 5 – 3, to keep interest rates at the current level of 0.25%. That meant three members of the committee voted to raise interest rates, whilst five voted to stay put. The market had been expecting a split of 7-1. The market had been expecting a nearly unanimous decision to not increase the rates. So two more members voting in favor of a UK rate hike may means the UK is closer to a rate hike than previously thought. When the market believes an interest rate increase could be on the cards, the value of the currency will usually increase. This is what happened to sterling today.
|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.|
However, the picture isn’t so simple for the BoE, which is finding itself in a position with little room for maneuver. UK inflation is almost 1% above the BoE’s target of 2% and needs to be brought down. However, the 5 members who voted against the rate hike in today’s meeting believe that increasing interest rates will destroy economic growth. UK economic growth is very fragile; the UK economy is highly dependent on the service sector which requires consumer to spend. Given that wages, once adjusted for inflation, are actually falling, it’s easy to understand why households are holding back on spending. An interest rate rise could stall consumer spending altogether.
The U.S Federal Reserve has more capacity to act than the BoE given the less complicated picture surrounding the U.S economy. On Tuesday, as analysts had expected, the Federal Reserve increased interest rates. The U.S. central bank was also positive regarding the outlook of the U.S. economy, which has helped boost the dollar in trading since. A strong economic outlook means the Federal Reserve could look to raise rates again soon. The end of the week promises to be a little quieter for both the pound and the dollar with little in the way of high impacting data.
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