The British pound (commonly referred to as GBP) is one of the most liquid currencies in the world. The currency pair GBP/USD is one of the four most widely traded. Just as a reminder, the most commonly traded currency pairs are:
The very well-developed capital markets of the UK have greatly contributed to the liquidity of the currency. The UK represents the alternative point of asset investment different from the US. As a result GBP is needed to make the desired investments. This results in foreigners selling their domestic currency and acquiring the GBP.
Another characteristic of the GBP is its high interest rates, accompanied by well developed capital markets. Thus, the GBP attracts many carry traders who use it as their lending currency. Due to the wide popularity of carry trading, the GBP has increased in value.
Forex market traders tend to focus on the interest rate differentials of the UK Gilts/US Treasuries and the UK Gilts/German Bunds. Forex traders refer to these differentials because they provide an indication of the premium yield that is offered by UK fixed income assets over the US and European counterparts. They also show whether any currency changes are about to occur.
You should closely watch for changes in the UK bank repo since it is used as the major tool for monetary policies. In order to get information on potential changes in the bank repo you can listen to the comments made by government officials. An alternative source of information is the 3-Month Euro sterling futures. It presents market expectations for the interest rates of the eurosterling for the following three months. Information included in these documents can give a view on the future changes in interest rates that may be reflected in the value of the GBP.
The currency market is highly susceptible to the comments, remarks or polls that are done on the value of Euro. If, for example, any implication about UK adopting the Euro is done, then the value of the GBP will be decreased. If, however, comments that the UK will not yet adopt the Euro, the value of the GBP will increase. Another reason for the potentially decreased value of the GBP is the overall uncertainty surrounding the Euro adoption, since the EMU has a lot of problems to solve with its members.
Another characteristic of the GBP is its close relationship with the prices of energy. The major reason for this is the fact that some of the world largest energy companies are located in the UK. Thus, there is a positive relationship between the value of the GBP and the prices of energy. If the energy prices increase, the value of the GBP will rise as well since in order to buy energy from the UK the European countries will need more of its currency.
The currency pair EUR/GBP is the basic measure for the strength of the GBP. This is so since Europe represents the basic trade partner of UK. As a result any changes that occur in the value of EUR/GBP will be reflected on the GBP/USD and vice versa.
EUR/GBP rate = EUR/USD rate / GBP/USD rate
Whenever any differences in these rates are observed, they are viewed as a profit making opportunity by forex traders.