While the United Kingdom is a member of the European Union, is not part of the European Monetary Union, as has not yet adopted the Euro as its currency. There are various reasons for this, but perhaps the most well known one is the country’s forced withdrawal from the Exchange Rate Mechanism, the precursor to the Euro. Prior to joining the Euro, countries were required to meet certain criteria, one of which was to maintain the value of their currency within certain “bands”.
After at first attempting to stick to the conditions set out for joining the European Monetary Union, the value of the pound fell below the lower band, which forced the country out of what would become the European Monetary Union. Although the UK has ruled out joining the European Monetary Union for the foreseeable future, it is believed that the UK will eventually adopt the Euro, and as a result any such talk can effect the value of the pound.
Gordon Brown, the former Prime Minister of the United Kingdom outlined 5 broad economic tests that must be passed, before the UK could adopt the Euro as its currency. In addition to these criteria the UK would also have to meet the requirements set forth in the Maastricht treaty, which we discussed in our lesson on the Euro.
It should also be taken into account that the UK economy is a service based economy, with a particular emphasis on financial services, as well as the fact that it is a net exporter of oil and natural gas, so any changes in energy prices have an effect on the value of the currency.
The GBP/USD is a very actively traded currency pair. The GBP is also very active in the crosses, and as the EU is their largest trading partner, traders take a particular interest in any movements in the EUR/GBP for pointers on the fundamental direction of the currency.
The UK used to have one of the highest interest rates in the G7 which led to it being used as the buy currency for many traders when utilizing the carry trade as we discussed in a previous lesson. This caused the GBP/JPY to be one of the more active crosses in the market and one which traders who were looking for high levels of volatility often preferred to trade.