A country’s currency is affected by a number of economic indicators, such as interest rate differentials, economic news, the demand and supply of the currency, and future expectations of the country and currency.
Interest rates play a key role. All else being equal, the currencies of stable countries with higher interest rates tend to rise against the currencies of stable countries with lower interest rates. This is because higher interest rates create demand for that currency because people and businesses will buy the currency and invest it in that country to receive the higher interest. Individuals can do this by simply buying a higher-interest rate currency relative to a lower-interest rate currency. This is referred to as a carry trade.
Economic news tells traders how the UK is performing. Traders then compare this information to the rest of the world and decide which currencies look more promising going forward.
Supply and demand are largely driven by the above factors. How a country is performing economically and its interest rate expectations may determine whether more people want to buy the currency (demand) or sell it (supply).
Future expectations also play a large role. Currencies aren’t only affected by what is happening right now, but what could happen in the future. Brexit, for example, created a large unknown. Traders sold GBP because they assumed others would as well in light of ongoing uncertainty. However, as it fell further, more traders predicted that brighter days and higher prices would come, so they started buying, pushing the pound up based on future expectations.
Lowering interest rates while other countries are not doing the same, or poor economic data (relative to expectations), are examples of catalysts that could cause the pound to decline.
