GBP Is Stronger than USD: Understanding the ReasonsGBP/USD is the third most actively traded currency pair on the foreign exchange market, after EUR/USD and USD/JPY. It is also one of the oldest pairs traded on forex. The British pound continues to cost more than the US dollar, despite the dollar overtaking it as the global reserve currency.
Why is the British pound stronger than the US dollar? In this FXOpen article, we look at the GBP/USD pair and the factors that keep the British pound strong to help you understand how to trade it.
What Is the GBP/USD Pair?
Currencies are always traded in pairs on foreign exchange markets. GBP/USD refers to the value of the British pound sterling against the US dollar – specifically, how many US dollars traders need to buy one pound. For example, if the GBP/USD exchange rate is 1.28, a trader would need $1.28 to buy £1. How come the British pound is always stronger than the US dollar? The answer is rooted in history.
A Brief History of the GBP/USD Pair
Until World War I, the British pound was the global reserve currency, accounting for over 60% of the world’s debt holdings. It was valued at just under $5. After the war, the US dollar began to strengthen, and by 1944, when the Bretton Woods system was introduced, the pound was pegged at $4.03. The Bretton Woods system fixed the US dollar to the gold price and established it as the unofficial global reserve currency.
After World War II, the value of the USD began to rise, and it overtook GBP as the primary currency used in international trade. The Bretton Woods system began to slowly collapse after 1971, and both the GBP and USD became free-floating, with the US dropping the gold standard. This has resulted in the value of the GBP gradually sliding over the following decades.
The free-float rate made the GBP/USD pair highly volatile.
The pound sterling reached a high of 2.08 against the dollar in 2007 during the global financial crisis, as higher UK inflation raised expectations that the Bank of England would raise interest rates.
In June 2016, the UK’s vote to leave the European Union drove the value of the pound down to the 1.20–1.25 area overnight. That was its lowest level since the collapse of the exchange rate mechanism in 1985 and the largest one-day decline since the end of Bretton Woods. The GBP/USD pair has since largely traded between 1.20-1.40. A notable exception was the start of the COVID-19 pandemic, when investors flocked to the safe haven US dollar amid uncertainty about the economic impact, and the pound fell to 1.16 against the USD.
COVID-19 shutdowns and the loss of European trade following Brexit have weighed on the prospects for the UK economy. At the same time, geopolitical tensions such as the US-China trade war and the Russia-Ukraine conflict have lifted the value of the dollar, as have rising interest rates.
In 2022, the Bank of England was forced to intervene as the value of sterling fell close to a record low of 1.035 against the dollar in response to a crisis of confidence in the UK government, high inflation and unemployment rates, and concerns regarding the domestic economy. However, by April 2023, the pound had recovered and became the best-performing G-10 currency of the year. According to Forbes, the British pound is the world’s fifth strongest currency, while the US dollar is the 10th strongest. The GBP/USD pair has primarily been trading around 1.20-1.30 so far in 2023. Why is the pound still stronger than the dollar?
Is GBP Stronger than USD?
Why is the pound more expensive than the dollar? The value of the GBP against the USD in forex doesn’t solely determine the strength of the US and UK economies. Analysts consider other factors that can question the strength of the pound.
Nominal Value
A currency’s nominal value refers to its value against another currency in forex. As was mentioned above, the nominal value of both currencies changed significantly over time. Although GBP was always more expensive than the US dollar, this conclusion is relatively arbitrary. Also, it’s worth considering the lower number of British pounds in circulation, which is worth £81 billion, compared to $2.33 trillion US dollars, which contributes to the higher value of GBP as of May 2023.
Relative Strength
The strength of a particular currency against another at any point in time is also relative, as it could actually be weaker against other currencies. For example, GBP could rise in value against USD but fall against EUR, AUD and JPY, which would suggest that the relative value of the pound is weaker – just not as weak as the USD. This is because the relative strength is determined not only by the value of one currency against another but by economic data, including inflation, economic growth, and the trade balance, which determine the strength of the overall economy.
To gauge a currency’s real strength, analysts track its value in relation to multiple currencies over time. For instance, the Dollar Index (DXY) measures the value of the USD against a basket of currencies from its key trading partners and competitors, as this is a more accurate measure of its value than a single pair.
Quoting Conventions
The use of GBP/USD as the quoting convention reflects the pound’s strength. For instance, a GBP/USD quote of 1.25 signifies that $1.25 is needed to buy £1.
This quoting convention originated in the late 1900s during the British Empire when the UK had a larger economy than the US. Despite the subsequent shift in economic power, this convention has endured. Since World War I, the US economy has surpassed the UK economy in terms of size.
Modifying quoting conventions is challenging, given how entrenched they are in the financial industry. However, the tradition of quoting GBP/USD in itself does not determine the value of the pound and the dollar.
Purchasing Power Parity (PPP)
While the GBP/USD trading value suggests the pound is stronger, the purchasing power parity (PPP) fluctuates. PPP indicates how much a currency is worth based on the value of a basket of goods. In these terms, the dollar can be stronger than the pound.
The concept underlying PPP is that the exchange rate should equalise the purchasing power of each currency within its respective country. For instance, if a basket of items costs £100 in the UK with a GBP/USD exchange rate of 1.15, the PPP would suggest that the equivalent cost of the same basket in US dollars should be $115.
In practice, exchange rates frequently diverge from their PPP levels. The degree to which a currency such as GBP or USD deviates from its PPP indicates its relative strength or weakness against another currency.
Global Economy
Although the US economy is stronger than that of Great Britain, sterling’s history as the former global reserve currency and political and economic power have contributed to its strength. The pound is one of the world’s oldest currencies, having been introduced in the 1400s. The UK remains a major global financial centre, and the Bank of England continues to participate in international economic developments.
What Factors Affect GBP/USD
There are several factors that affect the value of the British pound and US dollar:
US Federal Reserve monetary policy
Bank of England monetary policy
Inflation rate, which has a strong impact on the interest rates
Employment data, which influences government fiscal policy
Geopolitical events
Other economic indicators, including retail sales and industrial production
Does It Matter If GBP/USD Falls Below Parity?
A weaker sterling could support UK exports, but it would also increase the cost of imported goods and drive up inflation. The Bank of England would be forced to intervene to contain inflation. As seen in 2022, there is also a risk that a sharp drop in the pound’s value could become disorderly, which could create political and economic turmoil.
However, if the value of the pound fell below the dollar, it would be a psychological milestone for the UK, but it would not have a major impact on the forex market.
Conclusion
The British pound sterling has traditionally maintained a higher value against the US dollar because of historical convention. However, the US dollar is stronger overall as it is the world's reserve currency and has larger trading volumes. The GBP/USD exchange rate has been in a long downtrend. Therefore, there are risks that GBP will soon lose its nominal premium.
Understanding how the British pound is stronger than the US dollar can help you to form strategies to trade the GBP/USD forex pair. By observing economic indicators, you can take a view on how you expect the market to move.
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