By Brian Perry

Although it is small in terms of land mass, the economy of the United Kingdom (U.K.) is prosperous. The British (U.K.) pound sterling (or pound) plays an important role in the international financial markets; therefore, investors may want to consider trading it in a pair against the U.S. dollar.

The Economy Of The United Kingdom
For more than a century, the United Kingdom was the most powerful nation in the world. The U.K.'s economy was the world's largest, and the small island nation dominated international trade. During this time, the British pound served as the world's reserve currency. Following the World War I and II, the United Kingdom entered into a period of relative decline as the United States ascended to the position of the world's dominant economic power. The U.K.'s growth also stagnated as heavy government regulation and rigid labor markets impeded economic activity.

However, the U.K. remained reasonably prosperous, and since the 1980s, the country has regained much of its previously lost economic vitality. This rise has coincided with the U.K.'s enhanced reputation as a center for global finance. As U.K. and expatriate bankers have flocked to London to seek their fortunes, the financial sector has become a more important part of the U.K.'s overall economy. In fact, by some measures, financial services make up more than 10% of the U.K.'s total economic output. Therefore, the direction of the financial markets and the strength of the financial sector play a large role in determining the health of the U.K. economy.

The British (U.K.) Pound Sterling
Although the U.K. is a member of the European Union, the country remains outside the eurozone (the European Monetary Union) and maintains its own currency, the British pound sterling (known as the pound).

Before the U.S. dollar became the world's reserve currency, the British pound served that role for more than a century. The pound remains an important currency and a popular trading vehicle for traders of all types. The U.S. dollar and the pound are actively traded between each other, and the pair has earned a special nickname among traders, who call it "the cable" in reference to the time when bid and ask quotes were transferred between New York and London via underwater cables across the Atlantic. (For more on trading the GBP, see Top 8 Most Tradable Currencies.)

Trading the British Pound/U.S. Dollar
The British pound/U.S. dollar pair is one of the most liquid in the currency market. Bid-ask spreads are tight, and arbitrage opportunities are unlikely to exist. However, the liquidity of the pair combined with the availability of trading instruments makes the British pound/U.S. dollar an excellent choice for all types of currency traders.

As with the euro/U.S. dollar, the most important factor in determining the relationship between the U.S. dollar and the British pound is the relative strength of the countries' respective economies. When U.S. economic performance is stronger than the U.K.'s, the dollar usually strengthens against the pound. When the U.K.'s economy outperforms that of the U.S., the dollar generally weakens against the pound. This relative strength is often reflected in domestic interest rates, so traders should look carefully at the relationship between U.S. and U.K. interest rates. Because both the U.S. and the U.K. boast very large financial hubs, the performance of the countries' financial sectors and financial markets can also be important in explaining relative currency movements.

One unique aspect of trading the British pound is that there is often conjecture that the U.K. may choose to join the eurozone (or European Monetary Union, known as the EMU). If this were to happen, the U.K. would have to give up the pound and use only the euro. It is generally believed that if the U.K. were to join the EMU, it would first need to devalue the pound. Therefore, when U.K. politicians are speaking in favor of joining the EMU, the pound typically depreciates; when U.K. politicians speak against joining the EMU and in support of keeping an independent currency regime, the pound typically strengthens.


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