Foreign exchange, or forex, trading is an increasingly popular option for speculators. Ads boast of "commission-free" trading, 24-hour market access, and huge potential gains, and it is easy to set up simulated trading accounts to allow people to practice their trading techniques.
TUTORIAL: Popular Forex Currencies
With that easy access comes risk. It is true that forex trading is a huge market, but it also true that every single wannabe forex trader is going up against thousands of professions working for major banks and funds. The foreign exchange market is a 24-hour market and there is no exchange – trades take place between individual banks, brokers, fund managers and other market participants – but 10 firms dominate nearly 75% of the volume.
It is not a market for the unprepared, and investors would do well to do their homework beforehand. In particular, would-be traders need to understand the economic underpinnings of the major currencies in the market and the special or unique drivers that influence their value.
Introduction to the British Pound
The British pound (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 currencies 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 U.S. dollar in terms of its significance in international trade and accounting. Given the economic consequences of World War II and the breakup of the U.K.'s global empire, the pound lost its preeminence in the 1940s but 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 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 has 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 pound is one of the world's most popular traded currencies, and is heavily impacted by these factors. See 5 Reports That Affect The British Pound.)
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 U.K. 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 1990s, but traded at more reasonable levels withing 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 90s, 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 U.K. 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 U.S. 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 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 U.K. 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 U.K. itself.
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 many 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 – 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 bellweathers 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. Check out The Greatest Currency Trades Ever Made.)
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 U.K. 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 U.K. 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 U.S. 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 U.K. 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 pound will remain a preeminent global currency for some time to come. (Find out what makes currency swaps unique and slightly more complicated than other types of swaps. See Currency Swap Basics.)