Is the British Pound Stronger than the US Dollar?

Within forex trading, the comparison between currencies is a constant topic of discussion. One question often asked is whether the British pound is stronger than the dollar.

The U.S. Dollar is often seen as a stable currency, particularly in times of economic uncertainty, but is the dollar stronger than the pound?

Historically, the British pound has been worth more than the US dollar. However, there is more to currency strength than quoting conventions or currency values in a static period of time.

Several factors influence currency strength, including long-term price trends and the perception of a currency as a safe-haven. While historical tradition might favour the pound, the dollar's status as the world's reserve currency and its trading volume within forex markets may give it an advantage.

In this Plus500 guide, we'll explore the intricacies of currency valuation, examining the factors that shape the relative strength of the British pound and the dollar in today's economic landscape.

The GBP/USD Currency Pair Quoting Convention

GBP/USD ranks as the third most actively traded currency pair in the foreign exchange market, following EUR/USD and USD/JPY, accounting for around 11% of the market as of 2023.

One reason for the perception of strength in the British pound (GBP) compared to the U.S. dollar (USD) is the way the currency pair is quoted, GBP/USD, implying the British pound is stronger than the dollar. However, it's important to recognize that while quoting conventions holds historical significance, they do not inherently dictate the actual strength of the pound or the dollar.

The GBP/USD quoting convention originated from an era when the UK had a larger economy than the US during the late 1900s.

Despite significant shifts in global economic dynamics and the US economy surpassing that of the UK following World War I, modifying quoting conventions remains challenging due to how deeply they are ingrained within the financial sector.

What Makes A Strong Currency?

When determining the strength of currencies such as the British Pound (GBP) and the US dollar (USD), it's essential to understand that their strength is not fixed but rather contingent upon multiple factors, often spanning an extended period.

To gain insight into current currency values and strengths, understanding the history of the GBP/USD currency pair and the factors that have shaped currency value is essential.

GBP/USD Exchange Rate History

The history of the GBP/USD exchange rate is marked by significant shifts impacted by geopolitical events and economic policies. Dating back to the founding of the United States in 1776, the British pound held considerable strength, with one pound equaling approximately $5.

Throughout history, it has been a recurring theme that war significantly impacts currency values. During the U.S. Civil War, the pound experienced a notable surge in value against the dollar, peaking at $10 per pound. However, by around 1865, the exchange rate had reverted back to roughly $5 per pound.

The exchange rate experienced increased volatility during the World Wars and the Great Depression. Prior to World War I, the British pound held a position of prominence, serving as the world's primary reserve currency, representing over 60% of global currency reserves. At that time, its value was nearly $5.

World Wars I and II marked pivotal shifts in the currency dynamics, as the US dollar began its rise, eventually surpassing the British pound as the primary currency of international trade.

The introduction of the Bretton Woods system in 1944 solidified the dollar's position, pegging the pound at $4.03 and establishing the dollar as the dominant global reserve currency.

Subsequent decades witnessed the gradual decline of the pound's value against the dollar, exacerbated by the collapse of the Bretton Woods system in 1971, where the US abandoned the gold standard. This made both the GBP and USD free-floating currencies, allowing market forces to determine currency values.

Throughout the Great Recession, there was a notable decline in the value of the British pound. In April 2007, prior to the Great Recession, the GBP reached a record high doubling its value against the USD, but by 2009, it decreased below $1.40. This sharp decline amounted to a loss of over one-third of its value as investors sought refuge in the U.S. dollar, commonly perceived as a safe-haven currency during economic instability.

On September 18, 2022, the exchange rate between the currency pair fell to $1.07 per pound. This decline followed an announcement by British Chancellor of the Exchequer Kwasi Kwarteng, revealing the United Kingdom's plan to implement the most extensive tax reductions in half a century while concurrently increasing government borrowing and expenditure to address high inflation.

This prompted the Bank of England to intervene, declaring its intention to temporarily purchase an unlimited amount of government bonds to prevent chaotic trading activity from destabilising the British government.

This emphasizes the complex interaction between geopolitical factors and economic fundamentals that influence the dollar to pound relationship.

Recently, the pound sterling has exhibited indications of stability, maintaining a value against the dollar ranging between $1.19 and $1.30 per pound throughout 2023. This marks a slight recovery from its low point of $1.07 per pound in September 2022.

Historically, despite its fluctuations, the British pound has seen a higher value against the US dollar. However, it's important to recognize that a currency's exchange rate relative to another currency isn't the sole determinant of its overall strength.

Factors That Influence Currency Strength

Understanding currency dynamics involves considering many economic indicators, such as interest and inflation rates, purchase power parity, trade balances, geopolitical events, and economic outlook, all of which collectively shape market sentiment and influence overall dollar to pound value.

Interest Rate and Inflation Rate

Interest and inflation rates play important roles in determining the strength of a currency such as the British Pound or the US dollar. Central banks can wield considerable power by manipulating interest rates, which in turn affect both inflation and exchange rates.

Typically, higher interest rates increase a country's currency value. This occurs because higher interest rates attract foreign capital, leading to increased demand for the home currency. In contrast, lower interest rates can weaken a currency's value as they make it less appealing for foreign traders.

For example, the British pound strengthened in December of 2023 following the announcement by the Bank of England (BoE) that it would maintain the UK's base interest rate at 5.25%. This interest rate represented a 15-year high and also helped to decrease the inflation rate.

Moreover, inflation rates also influence exchange rates. Countries with lower inflation levels generally experience appreciation in their currency's value. This is because lower inflation preserves the purchasing power of the currency relative to others.

On the contrary, countries struggling with high inflation often experience depreciation in their currency's value, decreasing purchasing power.

However, the relationship between interest rates and currency value isn't always straightforward. While high interest rates might seem indicative of a strong currency, governments might implement them to combat high inflation, which can offset the currency's potential value gain.

Understanding the impact of interest rates on currency values is crucial for forex traders determining currency strength. Central banks' decisions regarding interest rates provide vital insights into future currency movements.

Purchase Power Parity

Purchase power parity (PPP) is a concept in economics that facilitates the comparison of purchasing power among various world currencies. This comparison is important, as it reveals the relative strength or weakness of a currency against another.

Essentially, it calculates how much goods and services would cost if all countries used the same currency, effectively equalizing purchasing power.

To grasp purchase power parity in practical terms, we can illustrate using an example of The Big Mac Index, established by The Economist in 1986. This index gauges the relative value of currencies by comparing the price of a Big Mac burger across different countries.

Suppose a Big Mac costs $5.00 in the United States and £6.00 in the United Kingdom. According to purchasing power parity, the exchange rate should ideally be such that $5.00 equals £6.00. If the actual exchange rate differs significantly from this, it indicates whether the USD or GBP is overvalued or undervalued relative to each other, reflecting differences in purchasing power between the two currencies.

In the above example, this implies an exchange rate of 1 USD = 1.20 GBP.

If the actual exchange rate in the market is above this, let's say 1 USD = 1.30 GBP, it indicates that the USD is overvalued relative to the GBP. In other words, goods and services are cheaper in the United States than in the United Kingdom when considering the Big Mac as a representative good.

On the other hand, if the actual exchange rate in the market is below this, let's say 1 USD = 1.10 GBP, it could suggest that the USD is undervalued relative to the GBP. This means goods and services are relatively more expensive in the United States compared to the United Kingdom, according to the purchasing power parity principle.

PPP comparisons are also instrumental in determining which country has the largest economy, providing a comprehensive understanding of the country's economic health when combined with gross domestic product (GDP) data.

Moreover, PPP values aid foreign currency traders in predicting currency fluctuations and identifying potential weaknesses.

Trade Balances

The trade balance also plays a significant role in assessing the strength of a currency. This balance, also known as the balance of trade or net exports, signifies the relationship between a nation's exports and imports.

Essentially, it reflects the demand for a country's goods and services, which extends to its currency as well. When a country exports more than it imports, it signifies a surplus in trade, indicating a higher demand for its products.

Consequently, this heightened demand often translates into increased demand for the country's currency, increasing its value in the foreign exchange market.

Analysts frequently refer to a country's balance of trade and its net trading position as key indicators of its currency's strength.

Geopolitical Events

Geopolitical events have played a significant role in shaping the strength of the British Pound relative to the US dollar in recent years. One pivotal event was the decision by the UK to exit the European Union, commonly known as Brexit.

The UK's departure from the European Union introduced complexities into its trade relationships. This significant decision eroded trust in the British economy among several nations, leading to a depreciation of the pound.

Before the June 2016 Brexit referendum, the pound was trading against the dollar at $1.44. However, following the referendum, within two weeks, the pound's value plummeted by over 20% to $1.33.

In the US, the lead-up to the 2020 election results caused the USD to decline against other currencies, as prolonged voting caused uncertainty brought on by a disputed election.

Both the Brexit decision and the uncertainties surrounding the 2020 US election can exemplify how geopolitical events can significantly impact the strength of currencies like the British Pound and the US dollar.

Economic Outlook and Market Sentiment

Despite historically low interest rates, the U.S. dollar maintains favourable exchange rates compared to most other currencies, a testament to its status as the world's primary reserve currency.

This position is further supported by the U.S.'s substantial gross domestic product (GDP), a metric often used by national central banks to gauge economic health and determine future interest rate adjustments.

The USD's dominance extends further, with it comprising 58% of global currency reserves as of Q2 of 2023 as reported by Statistica, solidifying its reputation as the ultimate safe-haven currency during periods of market turbulence.

The U.S. dollar's resilience as a safe-haven currency and its prominent role in global currency reserves highlights its enduring strength in the international financial landscape compared to the British pound.

Conclusion: Insights Into GBP and USD Valuations

The strength of currencies, particularly the British pound (GBP) and the US dollar (USD), is influenced by a myriad of factors.

While historical tradition and quoting conventions may suggest inherent strength in the pound, the dollar's status as the world's reserve currency and its deep integration within global financial markets may provide it with a distinct advantage.

Nevertheless, currency strength is not solely determined by exchange rates or quoting conventions; rather, it is shaped by intricate interactions between economic indicators, geopolitical events, and market sentiment.

Understanding these complexities is essential for mastering forex strategies by traders seeking to navigate the ever-evolving landscape of currency valuation when trading the GBP/USD forex pair.

FAQs: GBP and USD Currency Value

Is the British pound stronger than the US dollar?

The historical value of the British pound has often exceeded that of the US dollar. However, currency strength is influenced by various factors beyond historical conventions, such as economic indicators, geopolitical events, and market sentiment.

While the quoting convention (GBP/USD) may suggest a higher value for the pound, the dollar's status as the world's reserve currency and its deep integration within global financial markets give it a distinct advantage.

What factors contribute to a strong currency?

Several factors influence currency strength, including interest rates, inflation, trade balances, geopolitical events, and economic outlook. Central banks' decisions regarding interest rates, geopolitical events such as Brexit, and economic indicators like GDP collectively shape market sentiment and influence currency values.

What role do geopolitical events play in currency valuation?

Geopolitical events, such as Brexit or uncertainties surrounding elections, can significantly impact currency strength. These events affect market sentiment, leading to fluctuations in currency values. Understanding geopolitical dynamics is essential for forex traders seeking to navigate currency markets effectively.