We explained what the Bank of England does, but how does the Bank of England actually affect exchange rates (FX) in reality?
What are exchange (FX) rates?
Exchange rates are the price of one currency relative to another currency - easy stuff!
For example, you have Sterling (Great British Pound) vs the US Dollar (USD) and the price it is quoted at (GBPUSD) would be the amount of dollars you would receive for every £1 bought.
But the mechanism for actually predicting where a currency pair will go is not so.
The largest component of exchange rate moves comes down to the base rate (interest rate) differentials between the two currencies quoted!
Let us explain how...
Exchange rates are determined by interest rates (kinda)
The Bank of England changes interest rates as a response to the inflation backdrop and the economic conditions in the UK, like all the other central banks globally.
By doing so, this then affects fixed income (aka bond) markets and the price at which the government pays to bondholders who decide to lend to them by buying the bonds (in the UK's case, Gilts).
There are many aspects to how exchange rates move, but the Bank of England rate setting is absolutely the most important.
When the Bank of England raises interest rates, Gilts sell off, driving the yield higher and when Gilts are bought, the yield falls.
Check out our FANTASTIC guide on everything to do with bonds and fixed income.
Let's picture a scenario where the Bank of England raises the base rate by 50bps (from 0.5% to 1%) but the Federal Reserve raises the US' interest rate by 75bps.
There is then a differential of 25bps in favour of the US, even though the Bank of England also raised rates.
Money likes to be placed where it can earn a profit the easiest.
So if interest rates are higher in the US vs the UK on a relative basis, money will move from the US to the UK.
This would involved buying the dollar and selling the pound (if you are buying GBP you are short the dollar)!
Back in September, this is pretty much what happened and was amplified due to Liz Truss' Mini Budget - have a look at GBPUSD below.
The market was already heading lower based off of the interest rate differential and the mechanism decided above after the Bank of England decided to hike less than the Federal Reserve.
Everything in markets is about relativity, especially when it comes to stocks and interest rates.
If you keep this in mind when the Bank of England are about to talk, you can absolutely come to a better conclusion as to where the FX market is headed!
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