Pound Dollar Exchange Rate Hit by Brexit Volatility and US Inflation

13.10.17
4 minute read
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Thursday was a very volatile session for the pound, as Brexit headlines pushed sterling to its lowest level in 4 days against the dollar, before boosting it to a weekly high. Heading into Friday, the pound US exchange rate was trading at US$1.3265 for sterling.

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 dropped by over 100 points versus the dollar in early trading on Thursday before charging higher. Chief EU negotiator, Michel Barnier, first quashed hopes of a post-Brexit transition by saying that sufficient progress hadn’t been made to move Brexit talks forward. The next stage of talks could include discussions on the post-Brexit transition deal and UK-EU future trade agreements. Any hints that discussions aren’t progressing puts pressure on the pound, as it smashes hopes of a smooth and transitional post Brexit period.

Why is a smooth Brexit good for the pound?
A smoother Brexit would be a scenario in which the economic consequences of leaving the European Union are minimised. This is favourable for the pound because the less the Brexit impact on the economy, the more likely that foreign investors will remain interested in the UK. Foreign investors need sterling to invest in the country and so the more GBP is purchased, the higher the demand and, thus, an increase in the currency’s value.

Towards the end of Thursday’s session reports circulated that Barnier could offer the UK a 2 year transition period. This would keep the status quo in all but name for 2 years following Brexit in 2019. Should the transition period be agreed upon, then the UK would remain part of the single market and the customs market until 2021. The pound rallied on the news, as this would prevent a cliff-edge or Hard Brexit, which is good news for UK businesses and therefore the UK economy.

The pound is extremely sensitive to any hints or clues regarding the transition period. Should headlines today indicate a change of stance then the pound could swiftly fall.

US Inflation to edge closer to 2%?

The dollar was finally in favour again on Thursday, picking itself up after being under pressure for the past week. The dollar moved higher following data that showed inflation at factory level (Producer price index - PPI) increased more than analysts were expecting on a year on year basis. The PPI measures prices at the wholesale or producer level, and includes all of the physical goods producing industries in the US. The PPI increased by 2.6% on an annual basis, ahead of the 2.4% predicted by analysts. This is a good precursor for inflation, as measured by the consumer price index (CPI) which accounts for prices in consumer goods and services such as food and health care.

The CPI is a closely watched high impact data point. It’s closely watched because higher inflation increases the odds of an interest rate hike. Currently, the US is experiencing low inflation, which is proving to be troublesome to the US Federal Reserve. The Fed is looking for inflation to pick up above the 2% target level. The Fed has hinted strongly that it will raise interest rates in December, almost regardless of weak inflation. However, dollar investors are looking beyond the near term and persistently weak inflation could prevent Fed from continuing to raise rates in 2018. A weak reading on the CPI today could pull the dollar lower as investors would lower their hopes of more interest rate hikes next year.

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.
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