Intro to Trading the British Pound

09/16/2011 6:00 am EST

Focus: FOREX

The British pound is one of the world’s most important and actively traded currencies, and those who trade it must be keenly aware of the policies, news, and events that act as key price drivers.

The British pound (GBP) (also called the pound sterling) is one of the most economically and financially important currencies in the world. The pound is the fourth-most-traded currency in terms of turnover and it is the third-most widely held reserve currency among the countries of the world. 

The pound holds a significant place in economic history, as it was once the world's dominant currency and held the position now owned by the US dollar in terms of its significance in international trade and accounting. Given the economic consequences of World War II and the breakup of the UK's global empire, the pound lost its preeminence in the 1940’s, but it has certainly not slipped beyond relevance.

The pound also holds an interesting place in the history of hedge funds and currency speculation. Britain joined the European Exchange Rate Mechanism in 1990, a "semi-pegged" exchange rate system in Europe that was meant to ease some of the volatility in exchange rates and prepare the way for a single currency. Unfortunately, the system did not provide the advertised benefits and Britain experienced both recessionary pressures and high outflows from the Bank of England (BOE) in a vain effort to maintain the stated rate.

Currency speculators, led most famously by George Soros, bet that this rate could not hold (as economic conditions made it unsustainable) and aggressively shorted the pound. Ultimately, Britain withdrew from the system (on Wednesday, September 16, 1992, known as "Black Wednesday") and Soros alone profited in excess of $1 billion from his moves.

All of the major currencies in the forex market have central banks behind them, and the pound is managed by the Bank of England. While almost every Western central bank views inflation control as a preeminent mandate (along with promoting some level of economic growth), the Bank of England has explicitly followed a policy of targeting 2% inflation.

The Economy Behind the British Pound

Looking at nominal GDP, as of 2011, the United Kingdom is the sixth-largest economy in the world. The UK has enjoyed consistent (albeit not spectacular) growth for most of the past two decades, with the global credit crisis and recession taking its toll in 2008. Inflation has been an intermittent issue; inflation ran as high as 8% in the early 1990’s, but settled at more reasonable levels within the last couple of years.

More potentially worrisome has been the recent increase in debt as a percentage of GDP. After peaking near 50% of GDP in the late 90’s, Britain's balance sheet improved consistently. Since 2008, though, debt has increased sharply.

While Britain does belong to the European Union, it is not a member of the Eurozone, meaning that it retains complete sovereignty over its fiscal and monetary policy. Even by the standards of Europe, though, the UK has a highly globalized economy and London is regarded as the world's second-most important financial center. Perhaps not surprisingly, then, Britain is seen as a viable alternative for companies wishing to raise capital without the expenses and hassles of complying with US securities regulations.

Britain has generally pursued pro-business policies and is a major global competitor in advanced industries like pharmaceuticals and aerospace, as well as services like banking, finance, advertising, and accounting. Britain is an aging country, but it has a globally competitive workforce. 

While the United States is Britain's largest single trading partner, Europe as a whole is a major source of both imports and export demand. Consequently, economic conditions and policies in Europe have a major impact on the economic health of the UK, and traders who wish to trade the pound would do well to follow the Eurozone economic data almost as closely as the data from the UK itself.

NEXT: Key Price Drivers of the British Pound

|pagebreak|

Key Price Drivers of the British Pound

Economic models designed to calculate the "right" foreign currency exchange rates are notoriously inaccurate when compared to real market rates, due in part to the fact that economic models are typically based on a very small number of economic variables (sometimes just a single variable like interest rates).

Traders, however, incorporate a much larger range of economic data into their trading decisions, and their speculative outlooks can themselves move rates just as investor optimism or pessimism can move a stock above or below the value its fundamentals suggest.

Major economic data includes the release of GDP, retail sales, industrial production, inflation, and trade balances. These come out at regular intervals and many brokers, as well as financial information sources like The Wall Street Journal and Bloomberg, make this information freely available.

Investors should also take note of information on employment, interest rates (including scheduled meetings of the central bank), and the daily news flow, as natural disasters, elections, and new government policies can all have significant impacts on exchange rates.

With its stated policy of maintaining inflation around 2%, the interest rate announcements (and commentary) from the Bank of England are tremendously significant to how the pound trades. Along similar lines, traders frequently monitor major commodities like oil, natural gas, and grains as bellwether markets for possible inflationary pressures.

Britain is also a major destination for global investing, and those flows can certainly influence exchange rates. Britain has increasingly become a favored alternative destination to New York for raising capital, and that activity influences the currency. The carry trade is not a tremendously significant factor for the British pound. (These speculators took big positions and scored huge profits in the currency market.)

Economic Reports That Affect the British Pound

Prices and Inflation
Report to Focus on: CPI, PPI

The first important factor, price and inflation, plays a crucial role in the value of the GBP. In general, countries with high levels of inflation relative to other countries see their currency value depreciate more compared to those other currencies. In addition, inflation also usually causes the central bank to take action, such as adjusting interest rates to control these unwanted effects.

To gauge levels of inflation in the UK, traders will typically follow the Consumer Price Index (CPI), compiled and released by the Office for National Statistics. The CPI calculates the change in prices of goods and services purchased by consumers in a given period. This report is important because it is the measure that the Bank of England uses for its inflation target. Any changes in the CPI that deviate from the BOE's inflation target could imply future monetary policy action that could significantly affect the GBP.

In addition, although consumer prices tend to affect the majority of changes in the level of inflation, other measures such as the Producer's Price Index (PPI) are also useful. The PPI is considered by many a leading indicator of inflation because it shows inflationary changes at the raw material level that could eventually work their way up to the consumer level to be reflected in the CPI. The PPI report is also released earlier than the CPI, so both should be viewed together for a more complete picture.

NEXT: Key Reports on Monetary Policy and Sentiment

|pagebreak|

Monetary Policy
Report to Focus on: Bank Rate, BOE Inflation Report

Monetary policy enacted by the Bank of England is also an important factor to consider. One of the core mandates of the BOE is to promote monetary stability defined by the bank as "low inflation and confidence in the currency." Whenever the BOE feels that inflation is getting to a level that threatens the stability of the pound, the bank will use monetary policy tools at its disposable to control inflation. It is the timing of these monetary policies—such as interest rate changes—that traders want to predict.

To keep track of monetary policy, traders will follow the changes in the bank rate, which is the interest rate banks charge other banks on balances held at the BOE. The rate decisions are determined by the Monetary Policy Committee (MPC) on a monthly basis and can be found at the Bank of England Web site. Of note is that if the MPC simply maintains the previous bank rate, there will generally be no accompanying discussion. However, if there is a change in the rate, the MPC will release a statement which is more interesting and can give clues about future action.

Confidence and Sentiment
Report to Focus on: Gfk Consumer Confidence, Nationwide Consumer Confidence

Surveys that gauge market sentiment are another important tool for fundamental traders. Confidence and sentiment reports for the UK are important because traders want to know whether the majority of people are optimistic about the economy or pessimistic. The changes and the size of the change can be keys to detecting shifting trends in the underlying economy, and consequently changes in the GBP.

To track sentiment in the UK, many traders will follow the Gfk Consumer Confidence and the Nationwide Consumer Confidence Index (NCCI) reports. Both reports are surveys based on five questions that relate to the general economic environment, employment, and expectations for the future.

The main difference between the reports is the time periods used. For the NCCI, the survey reflects the respondent's feelings towards their current situation and their expectations for the next six months. On the other hand, the Gfk reflects the respondent's feelings towards events that happened in the previous 12 months, and their expectations for the next 12 months. Both can be used to gauge sentiment towards the direction of the UK economy.

GDP/Economic Growth
Report to Focus on: Manufacturing PMI, Services PMI, Retail Sales, GDP

The overall level of economic activity in the UK is another key factor that can impact currency values. The primary measure of economic activity in the UK, as in many other countries, is the gross domestic product (GDP). There are three different GDP reports traders should be aware of: preliminary GDP, revised GDP, and final GDP.

The preliminary GDP estimate is released the earliest and tends to have the biggest impact because it gives traders a first look into the economic health of the UK. The preliminary GDP is also the least accurate and tends to be revised in the follow-up revised GDP and final GDP reports.

In addition, because the GDP is a quarterly report, many traders will supplement that report with more frequent indicators of economic activity such as retail sales, manufacturing PMI, and services PMI. As consumers are generally considered by many as the drivers of economic activity, retail sales are usually given a larger weighting of importance.

NEXT: Unique Factors for Trading the British Pound

|pagebreak|

Balance of Payments
Report to Focus On: Trade Balance, Current Account

Lastly, the balance of payments (BoP) for a country is an accounting record of its interaction with the rest of the world. The BoP is made up of three accounts, but generally only the current account is of interest to forex traders.

The current account shows how much a country is exporting and importing, and the flow of income payments and transfer payments. In general, a current account surplus is positive for the currency as it shows more capital is flowing into the currency than leaving, and a deficit is negative for the opposite reasons.

Also, it should be noted that the trade balance report is released monthly, while the current account is released quarterly. If you are just looking for imports/exports data, then the trade balance would be the report to use.

Unique Factors for the British Pound

As the third-most widely held reserve currency, the British pound holds a place of significance that seems somewhat outsized to its economic role in the world. Part of this is no doubt due to the country's status as a financial trading center and financial capital for Europe, but some of it is also due to the country's long history of global leadership.

The UK also enjoys a somewhat volatile reputation as a relative prudent and conservatively run economy. While this perception certainly ebbs and flows on the basis of which party rules the country (and the extent to which those policies favor or curtail public spending and transfer payments), there is nevertheless a widely held view that the UK will typically target prudent and conservative policies aimed at consistent (albeit not exciting) growth.

It is also worth noting that the pound is one of the relatively few currencies that is worth more than the US dollar (meaning that one pound buys more than one dollar).

The Bottom Line

Currency rates are notoriously difficult to predict, and most models seldom work for more than brief periods of time. While economics-based models are seldom useful to short-term traders, economic conditions do shape long-term trends.

Britain may be small in terms of its population and land mass, but it is a major global economy with a very long and rich history of global economic leadership. The UK has seemingly found a good balance between manufacturing and services for its economy, while pursuing policies geared towards stability and predictability.

As a strong alternative to the dollar, it is likely that the British pound will remain a preeminent global currency for some time to come.

By Stephen D. Simpson, CFA, contributor, Investopedia.com

Stephen D. Simpson, CFA, is a freelance financial writer, investor, and consultant. He has worked as an equity analyst for both sell and buy-side investment companies in equities and fixed income. Stephen's consulting work has focused primarily upon the health care sector, while he has also written extensively for publication on topics pertaining to investments, security analysis, and health care. Simpson operates the Kratisto Investing blog.

Related Articles on FOREX

Keyword Image
The Fabulous Shrinking Renminbi
09/27/2017 1:13 pm EST

As of August 2015, renminbi (RMB) in payments globally accounted for 2.8 percent of the total, the f...