The UK has a service-oriented economy, with manufacturing representing an increasingly smaller portion of GDP, equivalent to only one fifth of national output. Their capital market systems are one of the most developed in the world, and as a result finance and banking have become the strongest contributors to GDP. Although the majority of the UK's GDP is from services, it is important to know that they are also one of the largest producers and exporters of natural gas in the EU. The energy production industry accounts for 10% of GDP, one of the highest shares of any industrialized nation. This is particularly important, as increases in energy prices (such as oil), will significantly benefit the large number of UK oil exporters.

Overall, the UK is a net importer of goods with a consistent trade deficit. Its largest trading partner is the EU, with trade between the two constituencies accounting for over 50% of all of the country's import and export activities. The US, on an individual basis, still remains the UK's largest trading partner. The breakdowns of the most important trading partners for the UK are the following:

A long-term issue that the UK is grappling with is whether or not to join the Euro. The decision on Euro entry has significant ramifications for the UK economy. Currently, this is the key political and economic agenda on the government's plate. The Treasury has specified five economic tests that must be met prior to Euro entry. These tests are:

UK's Five Economic Tests for Euro

1. Is there sustainable convergence in business cycles and economic structures between the UK and other EMU members, so that the UK citizens could live comfortably with euro interest rates on a permanent basis?
2. Is there enough flexibility to cope with economic change?
3. Would joining the EMU create an environment that would encourage firms to invest in the UK?
4. Would joining the EMU have a positive impact on the competitiveness of the UK's financial services industry?
5. Would joining the EMU be good for promoting stability and growth in employment?

Key Economic Indicators for GBP Housing Starts
Housing has long been one of the strongest pieces of the UK economy, and this periodically creates concerns that the housing market may be creating a bubble. A second concern is that a runaway housing market could cause inflationary pressures. For these two reasons, stronger than expected housing numbers can be a preliminary sign that a hike in interest rates is on the way.

Retail Price Index (RPI-X)
The RPI-X is an inflation indicator that measures the prices of consumer goods. The market follows the RPI-X that excludes mortgages, and the target set by the BoE for inflation is a 2.0% annual growth in RPI-X. A sharp rise in the RPI-X could be seen as an indicator of future interest rate hikes in GBP, as the Bank of England attempts to curb inflation. The BoE has recently started using the HICP as an indicator of inflation rather than RPI, and HICP excludes housing as a measure of inflation, so there is a greater separation between housing prices and other consumer prices as measures of inflation, but both certainly weigh on the BoE when it makes interest rate decisions.

Energy Prices
Because the UK is a large exporter of crude oil, higher energy prices can affect the demand for the GBP and, in turn, its exchange rates. There is an energy component in the HICP, but large swings in energy prices can occur in real time, while the HICP data is not compiled until a later date. This means that swings in energy prices can be a very early sign of inflationary pressures, which can then affect interest rates.   Trading GBP GBPUSD
Like other major USD crosses, GBPUSD often moves more on dollar weakness than it does on GBP strength. Trading volume remains higher in GBPUSD than any other GBP pair, but it often reacts to moves in EURUSD and EURGBP. GBPUSD is an effective carry trade because of the large interest differential between the two currencies that may grow in the coming months. When the market is moving on GBP strength rather than on USD weakness that ties GBPUSD to other USD crosses, GBPUSD can move in large daily ranges over several hundred pips. It often trades in a range for several days or even weeks before breaking out to a new level and trading in a range again. This means that both the range trade and the breakout strategy can be profitable, as long as traders are willing to quickly cover losses if the market conditions seem to be changing.

EURGBP
Like exchanges with the Swiss France, those between the Euro and the British Pound have surpassed GBPUSD as an indicator. Trading volume is comparatively higher in GBPUSD, but major moves in EURGBP that show GBP strength or weakness will typically influence the movement of GBPUSD. Often the strength of the pound against the dollar will closely mirror that of the Euro, and there will be little in the way of decisive movement between the Euro and Sterling. If the market starts to trade on GBP or EUR strength, though, rather than on USD weakness or strength, there can be decisive movement in EURGBP.

Discussion Point for GBP
The UK would have to make major sacrifices in order to join the Euro, giving up a large degree of control over its own economy. What reaction in GBP strength would you expect if there were news released that made a merger with the EUR seem more likely (even if not in the near future)?

Note:

Jimmy Young is a seasoned institutional forex trader having 20 years of experience with different banks. He headed up bank FX dealing rooms. He is FX profitability consultant to major European private bank. He manages funds and also trades personal money. Between 1981 and 2004 he was a foreign exchange trader at following banks: Societe Generale, Julius Baer, Fuji Bank, Indosuez, Erste, Hill Samuel, Manufactures  Hanover, Paribas, European American. www.EurUsdTrader.com