Seven Factors that Drive the U.S. Dollar-British Pound Rate
AT-A-GLANCE
- GBPUSD tends to correlate positively with EURUSD
- Brexit-related politics played a significant role in influencing GBPUSD
- USD, EUR account for 80% of total foreign exchange reserves
- GBPUSD had a strong co-movement with oil benchmarks like WTI
- Investors expect BOE to hike rates at a slower pace than the Fed
In our recent article on the euro -U.S. dollar exchange rate (EURUSD), we identified four macroeconomic forces that influence the currency pair’s movements: 1) trade surpluses/deficits; 2) budget surpluses/deficits; 3) differences in economic growth rates and monetary policy, particularly with respect to investors’ expectations for future interest rate levels, and 4) the relative pace of economic growth. These factors also play a role in determining the exchange rate between the British pound and the U.S. dollar (GBPUSD), or “cable’ in trader jargon. However, GBPUSD also has three other key influences, which include:
- The EURUSD exchange rate, with which GBPUSD tends to be positively correlated
- The price of oil, which influences the trade deficits/surpluses of the U.K., U.S. and eurozone
- Brexit related politics, which may be fading in importance but played a large role in recent years.
GBP and its relationship with EUR
It’s difficult to understand the GBPUSD exchange rate without first understanding what is driving EURUSD (read our article here). The International Monetary Fund (IMF) estimates that as of Q1 2021, 59.5% of the world’s central bank currency reserves were held in USD and 20.6% in EUR. Together, the two currencies account for around 80% of total foreign exchange reserves. GBP was the fourth most widely held currency (behind the Japanese yen), accounting for 4.7% of global reserves (Figure 1). If one imagines the global currencies as a solar system, the USD is the star at the system’s center. EUR will be the system’s largest planet and the other European currencies, including GBP, are akin to moons that have eccentric orbits around EUR.
Figure 1: Forex reserves in GBP are a quarter of those in EUR and 1/15 those in USD
Together, a moon and a planet have a common center of gravity, but being larger, the planet’s gravity has a greater influence on the behavior of the system. Within Europe, the eurozone’s GDP amounts to $11.8 trillion, compared with $3.1 trillion for the U.K. Their relative size is also reflected in trade flows: 44% of U.K. exports head to the eurozone, but only 16% of eurozone exports head to the U.K.
As such, perhaps its not surprising that EURUSD and GBPUSD exhibit both a strong co-movement (Figure 2), and have had a consistently positive one-year-rolling correlation since 1980 (Figure 3). When EUR rises or falls versus USD, it often pulls the pound along with it. The pound exerts some influence on EUR as well. However, the relative size of the two currency areas in terms of GDP, trade flows and central bank reserves is not equal, so GBP’s influence on EUR tends to be weaker than EUR’s influence on GBP. This much was evident in the aftermath of the 2016 Brexit referendum when the pound plunged 20% versus USD over a three-month period while EUR fell only a few percent.
Figure 2: EUR and GBP tend to track one another versus USD
Figure 3: GBP and EUR have had a positive one-year rolling correlation for the past 40 years
Oil and GBP
While GBPUSD may revolve around EUR to some extent, its orbit is an eccentric one that varies over time. Over the past several decades one British pound has bought anywhere from 1.7 euros (or at times more) on the high side to as little as 1.1 (or occasionally fewer) euros on the low side. Aside from having its own separate monetary and fiscal policy, the U.K. has one thing that the eurozone has never had: a significant quantity of domestically produced oil, thanks to the discovery and exploitation of North Sea crude.
When it comes to oil, the U.K. differs from the U.S. as well. Although the U.S. is also a large oil producer, before 2020 it was a net oil importer. And before the advent of large-scale fracking circa-2008, U.S. imported roughly as much crude oil as Europe.
By contrast, from 1981 to 2005 the U.K. was a net oil exporter (Figure 4). Since 2006, the U.K. has been a net oil importer, but its oil imports are much smaller than those of the eurozone. The U.K.’s North Sea oil production peaked in 1999 and steadily shrank until 2015 before stabilizing and increasing slightly during the past six years. The shrinkage and subsequent stabilization of the oil production explains to some extent GBP’s decline versus EUR (Figure 5).
Figure 4: The U.K. has often been a net oil exporter in contrast to Europe
