Currency Strength

Currency Strength
Currency strength in fundamental analysis

GBP Currency Strength Pre-and-Post Brexit

On Thursday, 23 June 2016, the GBPUSD currency pair was trading at 1.4798. On that date, the UK voted to leave the EU. The result of the Brexit referendum was 52% in favour of Brexit, and 48% against. Northern Ireland and Scotland voted to remain part of the EU, while England and Wales voted overwhelmingly to leave. Following the results of the referendum, The Cable (GBPUSD) plummeted. It dropped to 1.3152 within 4 days, sparking a huge sell-off of GBP in the forex markets. Brexit-related concerns weighed heavily on the GBP, given the uncertainty of a UK withdrawal from the 27-nation bloc.

Trade agreements would have to be renegotiated, political rifts healed, and new alliances formed. The instability of an unprecedented event such as a Brexit had far-reaching implications on major currency pairs such as the EURGBP, GBPUSD, GBPJPY, and GBPCHF, among others. Immediately following the Brexit decision, Prime Minister David Cameron promptly resigned and was replaced by Prime Minister Theresa May. 

The rancour created by heated Brexit discussions dramatically affected currency trading activity, with bearish sentiment vis-a-vis GBP trading. The UK government failed to secure a meaningful vote (432 votes to 202 votes) on January 15, 2019, on a Brexit deal with the EU. Again, on March 29, 2019, the UK government lost its third meaningful vote on a Brexit deal, by 58 votes.

After Prime Minister Boris Johnson was elected, he urged the EU to drop the Irish backstop as part of the withdrawal agreement. The EU refused. By September 9, 2019 a law was passed (Benn bill) which prevented the UK from unilaterally leaving the EU without an agreement in place. After much back and forth between UK parliamentarians (Labour and Tories), another general election was held on December 12, 2019.

The Conservatives gained an 80 seat majority, while Northern Ireland, and to a lesser degree Scotland, remained vehemently opposed to Brexit. All this political wrangling weighed heavily on the GBP, driving down the value of the currency against major trading partners. The lack of consensus among UK parliamentarians and EU counterparts to get Brexit done was adding pressure to the GBP.

By January 23, 2020, a UK withdrawal from the EU passed into law in Britain. By January 29, 2020 the EU Parliament ratified the Brexit divorce deal, and by January 31, 2020 the UK officially left European Union at 11 PM GMT. From then onwards, the GBP gained in value as confidence returned to the Queen’s currency. Since the 2008 Financial Crisis, the GBP has actually been on a downward spiral, albeit a slow one. The tepid recovery since then is being eyed with caution by currency traders who understand that slower productivity growth will invariably place downward pressure on the GBP.

In 2021, the GBPUSD currency pair has appreciated strongly, heading towards its pre-Brexit highs of 1.47. Of course, the lag effect related to Brexit is likely to take several years to impact the currency. With the pandemic weighing heavily on production, manufacturing, employment, and economic growth, analysts remain cautiously optimistic about the GBPs prospects. A weaker GDP vis-a-vis the USD, JPY, and EUR will mean that UK purchases of foreign goods and services will be more expensive, while UK exporters will benefit.

What is Currency Strength?

Currency strength is the relative purchasing power of a national currency when traded for products or against other currencies. It is measured in terms of the quantity of goods and services purchased and the sum of foreign currency received in exchange for one unit of the national currency.

Normally, increasing economic value of a currency will enable its spenders to purchase larger amounts of products, while its earners will enjoy further financial empowerment with more valuable income.

A currency’s strength is determined by the interaction of a variety of local and international factors such as the demand and supply in the foreign exchange markets (forex); the interest rates of the central bank; the inflation and growth in the domestic economy; and the country’s balance of trade. Taking all factors into consideration, the currency strength can be evaluated in three dimensions:

  • Value: the relative purchasing power for goods and services in comparison to foreign currencies
  • Utility: the relevance as a financial valuation and exchange device in foreign economies
  • Reserve: the acceptability in international trade, driving foreign central banks to hold reserves

As the local production activities add further value to the country’s economy, higher purchasing power encourages spending. The surge in the supply and demand stimulates import and export, flourishing the international trade volumes.

The national currency gains utility in the trade-partner countries, which, in turn, drive their central banks to create reserves for it. Such acceptability enables commerce via a direct exchange of currencies without the mediation of a stronger currency like the U.S. Dollar.

It also provides room for manoeuvre in case a trading partner’s currency value fluctuates due to external circumstances. As a result, the national currency strengthens in the money markets and gains value in the Forex pairs.

The U.S. Dollar is currently considered as the strongest currency in the world. The U.S. economy has the largest consumer market, and the USD serves as the primary trade and reserve currency all around the globe.

Around 60% of the world’s central bank reserves, 40% of debt, 90% of forex trades, and 80% of global trade is denominated in dollars. When the world experiences a crisis, everyone looks to the U.S dollar as a shelter from risks. However, many countries and foreign companies borrow in U.S dollars and earn revenue or taxes in their domestic currencies, therefore dollar strength increases default risk.

How to Calculate the Currency Strength?

In the domestic economy, the strength of the national currency is calculated as the purchasing power when buying locally produced goods and services. It is based on income and wages reports which reveal the nominal earnings of the citizens.

The nominal income value is then adjusted to the inflation rate of the observed period to find the real income value. The real income figure represents the true economic value of the income amount in the pre-inflation economic conditions.

In the foreign exchange markets, a currency’s strength is measured in relation to foreign currencies in the Forex currency pairs. For example, EUR/USD currency pair is comprised of the U.S. Dollar and the Euro, the two largest reserve currencies in the world.

Their competition depicts the global economy’s preference and trust towards their respective economies. A variety of factors can affect the FX rate of the Euro-Dollar, including their internal economic climates, trade performances, and regional conditions.

On the other hand, when it comes to the currencies of the emerging markets like Brazil or China, their strength is measured against one of the major reserve currencies. For example, when the Chinese Yuan increases against the U.S. Dollar in the USD/CNY currency pair, the Chinese economy would be getting stronger and gaining more power in the global arena.

There are also currency strength indicators which gauge the overall strength of a currency in the global financial markets. Notably, the U.S. Dollar Index (“Dixie”) is the most popular currency strength meter and has a tradeable derivative ETF in the Intercontinental Exchange (ICE: DXY).

The USD Index compares the strength of the American Dollar against the currencies of the major trading partners of the U.S. It calculates a weighted average price of the USD currency pairs with Euro, British Pound, Japanese Yen, Canadian Dollar, Swedish Krona, and Swiss Franc. The Euro is the strongest currency in the Dixie with 57% weight, while the weakest currency is the Swiss Franc with only 3.7% weight.

Currency Strength as an Economic Indicator

The strength of a national currency can affect the country’s domestic economy and international trade activities in various ways. As a lagging indicator, the implications of a strengthening or weakening currency value might differ depending on the economic conditions as well as the economic policies.

Domestic Economy

Currency strength in the domestic economy refers to its purchasing power over locally produced goods and services. When the economy is stagnant, the central bank can cut the interest rates to reduce currency strength.

Decreasing borrowing costs accelerates production, and the national Gross Domestic Product (GDP) grows. Enhanced income and wages of the citizens translate into increased spending and consumer demand, leading to the inflation of consumer prices and allowing the businesses to enjoy higher corporate profits. Expansionary stimulation of the domestic economic activity helps the currency strength to increase in an organic fashion.

However, continuous strengthening of the currency can inflate the cost of living above affordable levels. Salary demands will rise accordingly, and the companies won’t be able to sustain profitability with high wages and expansion costs at the same time.

Lay offs will start and lead to higher unemployment rates, causing stagflation in the economy with high inflation and unemployment. The central bank will prevent this by slowing down the economy with an interest rate hike that would increase the currency strength.

International Trade

As the currency strength increases, importers will be able to purchase larger quantities with the same nominal amount or the same quantity with less nominal amount. At the same time, the exporters will enjoy added real value to their nominal income. However, the effectiveness of the currency strength is based on the economic policy adopted by the country.

For example, a country that adopts export-led growth, like China, would prefer a low currency strength to maintain the cost-effectiveness of the locally produced goods and services and to continue attracting foreign buyers. Thus, a relatively weaker currency will enhance its exports, and the Chinese economy will grow by receiving foreign currencies. On the other hand, countries that aim for import-led growth, like the U.S., care to have strong currency value which would enable them to enjoy a strong purchasing power that enables to import products in large quantities.

Currency Strength Indicators in Technical Analysis

Forex trading is all about buying strong currencies against weak ones; and selling weak currencies against strong ones. This means that no matter your trading style, information about currency strength is invaluable to any trader. Here are 2 major technical analysis indicators available for trading based on currency strength:

Absolute Currency Strength (ACS)

The ACS is available on most of the popular trading platforms and it is designed to measure the momentum strength of the 8 major currencies (USD, GBP, EUR, CHF, JPY, CAD, NZD, and AUD) in relation to 28 crosses between them. The ACS is calculated as a relative percentage gain or loss over a 15-period timeframe. The ACS can be traded for both short and long term outlooks, with higher percentages implying strong momentum, and lower percentages denoting weak momentum. The trading idea is always to buy strong currencies and sell weak currencies.

Relative Currency Strength (RCS)

Like the ACS, the RCS is also designed to measure the momentum strength of the major currencies (USD, GBP, EUR, CHF, JPY, CAD, NZD, and AUD). It does this by measuring their Relative Strength Index values across their 28 cross currency pairs. The RCS is calculated based on 14-period timeframes, with the indicator generating values between 0 to 100. The high and low values are 70 and 30. Values above 70 imply strong momentum in the underlying currency, whereas values below 30 denote weak momentum in the underlying currency. Like the ACS, the RCS can also be used when trading the market for both short term and long term outlooks.

Currency strength indicators provide vital information for forex traders. They help identify the best value currency pairs to trade at any given time. However, it is important that currency strength indicators are not a comprehensive trading strategy, and they should ideally be used in combination with other indicators.

How to Trade with Currency Strength?

Currency strength is the main determinant of the price rates of the Forex currency pairs in the financial markets. As most short-term traders from UK prefer news trading strategies, the economic events that influence a currency’s value can create significant market turmoil.

Such economic events include the central bank meetings and the interest rate decisions as well as the releases of economic reports such as Gross Domestic Product (GDP), Consumer Price Index (CPI), Unemployment Rate, Employment Change, and Balance of Trade.

When an economic event is about to happen, the previous results and the forecasted figures of the report or decision are published in the economic calendar. The market sentiment becomes salient as the long-term investors thoroughly analyse these forecasts and take their positions.

If the actual result is congruent with the expectations, the currency strength can increase or decrease accordingly, and cause the respective national currency to gain or lose value in the currency pairs.

However, if the outcome takes the investors by surprise, extreme volatility can occur as both investors and british traders would have to take more time to assess the details of the report and determine what the central bank might infer from the data.

Why Trade Currency Strength Reports with AvaTrade UK?

In Forex markets, the currency strength is the decisive factor for the foreign exchange rate of a currency pair. Considering most UK traders start their trading journey with FX pairs as they grasp the basics of trading and the macroeconomic factors that influence the markets, AvaTrade UK created a comprehensive toolkit to equip british currency traders with state-of-the-art tools.

  • When is the next Currency Strength report?
    Check the AvaTrade UK economic calendar to find all economic events for each currency and mark them in your calendar!
  • What can happen to the markets?
    Whether your favourite currencies rise or fall against others, you can use CFD trading to open Long or Short positions with lower margin requirements.
  • Do I have any risks?
    Financial trading comes with its own undeniable risks; however, our unique AvaProtect risk management tool will enable you to hedge with options on the spot!
  • What if I’m not in front of my computer?
    Download our AvaTradeGO mobile trading application and access the markets whenever there is a report that can affect currency strengths.
  • Can I ask for your help?
    AvaTrade’s award-winning support team is ready to provide assistance for Currency Strength reports and all other trading matters via chat, phone, and email.

Now that you know what affects the currency pairs in its essence, join the global arena of the Foreign Exchange and realise your potential in a market that has $5 trillion trading volume every day!

Currency Strenght main FAQs

  • How is the strength of a currency determined?

    A high exchange rate does not necessarily indicate a strong currency. The relative strength of a currency is seen over a long period of time. Changes are determined by supply and demand, as well as inflation and interest rates, among other things. Over a long period of time the British pound has become weaker as the British Empire has waned, yet the pound remains a stronger currency than the US dollar. And even though 1 yen is worth a little less than 1 US penny, over the long-term the yen has been consistently strengthening against the US dollar, going from an exchange rate of 300 yen to 1 USD in the early 1970s to the current exchange rate of just over 100 yen to 1 USD.

     
  • What does it mean when a currency is stronger?

    What precisely do we mean when we say that one currency is stronger than another? Generally, we are referring to the currency’s strength versus a specific other currency. So, the USD could at the same time be strong versus the GBP, but weak versus the JPY. The relative strength and weakness of a given currency versus a rival is influenced by a number of factors, but the most common are the interest rates of each country, the trade balance of each country, and the perceived stability of the currency and the governments.

     
  • Is it a good thing to have a strong currency?

    There are both pros and cons to having a strong currency. When a currency is strong it is less expensive, relatively speaking, to purchase the goods and services from the country with the weaker currency. Conversely demand for the goods and services in the country with the strong currency will typically decline because those goods and services are more expensive to the countries with weaker currencies. On a broader scale a strong currency for a long period of time could lead to businesses moving overseas to lower the price of their goods and services to other countries.