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Lesson 3

Factors Affecting Major Currencies

£

Bank of England (BoE): Under the Bank of England Act of June 1997, the BoE obtained operational independence in setting monetary policy in order to deliver price stability and to support the government’s growth and employment objectives. The price stability objective is set by the government's inflation target, defined as 2.5% annual growth in Retail Prices Index excluding mortgages (RPI-X). Hence, despite its independence in setting monetary policy, the BoE remains dependent on having to meet the inflation target set by the Treasury.

Monetary Policy Committee (MPC): The BoE's Committee responsible for making decisions on interest rates.

Interest Rates: The BoE's main interest rate is the minimum lending rate (base rate), which it uses to send clear signals on monetary policy changes in the first week of every month. Changes in the base rate usually have a large impact on the sterling. The BoE also sets monetary policy through its daily market operations used to change the dealing rates at which it buys government bills from discount houses (specialised institutions in trading money market instruments).

Gilts: Government bonds also known as gilt-edged securities. The spread differential (difference in yields) between the yield on the 10-year gilt and that on the 10-year US Treasury Note usually impacts the exchange rate. The spread differential between gilts and German bonds is also important, as it impacts the EUR/GBP exchange rate, which could affect the GBP/USD (see cross-rate effect).

3-month Eurosterling Deposits: GBP-denominated deposits at banks outside the UK are called Eurosterling deposits. The interest rate on 3-month sterling-denominated deposits held in banks outside the UK serves as a valuable benchmark for determining interest rate differentials to help estimate exchange rates. Following a theoretical example on GBP/USD, the greater the interest rate differential in favour of Eurodollar against Eurosterling deposits, the more likely it is the GBP/USD is to experience a fall. Sometimes this relation does not apply due to the impact of other factors. The difference between futures contracts on the three-month Eurodollar and Eurosterling deposits is an essential variable in determining GBP/USD expectations.

The difference between futures contracts on the three-month Eurodollar and Eurosterling deposits is an essential variable in determining GBP/USD expectations.

Her Majesty's Treasury: The Treasury’s role in setting monetary policy diminished markedly since the Bank of England Act of June 1997. Nevertheless, the Treasury still sets the inflation target for the BoE and makes key appointments at the Central Bank.

Economic Data: The most important economic data items released in the UK are: claimant unemployment (the number of unemployed), claimant unemployment rate, average earnings, RPI-X, retail sales, supply (M4), balance of payments, and housing prices.

3-Month Eurosterling Futures Contract (Short Sterling): The contract reflects market expectations on 3-month Eurosterling into the future. The difference between futures contracts on the three-month Eurodollar and Eurosterling deposits is an essential variable in determining GBP/USD expectations.

FTSE-100: Britain's leading stock index. Unlike in the US or Japan, Britain’s main stock index has a lesser influence on the currency. Nevertheless, the positive correlation between the FTSE-100 and the Dow Jones Industrial Index is one of the strongest in global markets.

Cross Rate Effect: The GBP/USD currency pair is sometimes impacted by movements in cross exchange rates (non-dollar exchange rates) such as the EUR/GBP. For instance, a rise in EUR/GBP (fall in GBP), triggered by strengthening expectations of the UK leaving the European Single Market, could lead to a decline in GBP/USD. Conversely, reports indicating that the UK will not leave the European Economic Area after all could hurt the EUR/GBP, thereby boosting the GBP/USD.


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