Trading Fundamentals: Breaking the Bank of England

At times, traders often wonder whether it is more profitable to trade on technical or fundamental indicators, and whether they should focus on either of the two. In reality, the two cannot be viewed as approaches which contradict each other but should be perceived as two interconnected approaches which should, if the analysis is properly conducted, point to the same conclusion. Still, this does not always hold: there are times though when technical factors are faster to catch the underlying trend, especially in short investment horizons, and then there are times when the underlying fundamentals suggest that a large move should take place and the market has not yet priced them in. In this latter category falls the story of George Soros, the man who broke the Bank of England in 1992, earning more than one billion Dollars in the course of a couple of days and securing a place in the Pantheon of traders.

To put things in perspective, let’s examine how the economic situation in Europe was during the period. To begin with, countries in Central Europe focused on having a fixed exchange rate regime (within certain bounds) among themselves. This effort, named the European Exchange Rate Mechanism (ERM) started in 1979, with the aim to create a “zone of monetary stability”. In the aftermath of the collapse of the Bretton Woods agreement, the oil price shock years in the 1970s, higher inflation, and large exchange rate volatility, the ERM aimed to repair these defects of the international financial system. Similar to the ERM II mechanism which is still followed to date for many non-Euro Area countries (e.g. Denmark, Bulgaria, etc.) deviations of +/- 2.25% from the agreed exchange rate are allowed.

At first, realingnments of the exchange rate were allowed, but these were not too often. Hence, the ERM essentially functioned as a fixed exchange rate area (such as the Euro Area), albeit allowing for setting an independent monetary policy across each country. Naturally, this led to diverging incentives across the countries which comprised the ERM, as inflation rates were very different across them. To address this issue, monetary policy in countries such as Luxembourg, Belgium, and the Netherlands started to adhere to policy in Germany, which, always fearing a resurgence of the hyperinflation period of the 1920s, recorded stable rates of inflation.

Other countries, such as Italy and Spain, did not converge to Germany’s monetary policy, as evidenced by the corresponding inflation rate differentials. In the aftermath of the 1970s, inflation was considered to be the cardinal sin, mostly because this was driven by supply-side factors, mainly as a result of the world economies trying to adjust to the higher oil prices observed, which provided a backstop to growth. When the UK joined the ERM in 1990, the inflation differential was much higher than considered in the exchange rate of 1 GBP for 2.5 Deutsche Marks (DM).

Nonetheless, the ultimate need for revaluation came as a result of the usual interest rate differentials. As higher inflation was observed in Germany, the outcome of higher demand growth, the Bundesbank raised interest rates to fight price pressures. The policy rate reached 8.75% in the summer of 1992, while the respective UK one stood at 6.8%, providing the ideal opportunity for a carry trade, also given the absence of capital controls. As exchange rates remained relatively stable, according to the ERM, currency speculators could borrow from the UK and deposit in Germany, benefiting from the differential, and securing an almost risk-free return. The macroeconomic situation in the UK was also adding to the exchange rate strain: the UK’s chronic large current account deficit, in contrast with a much smaller German one, thus increasing the supply of Sterling in the world.

George Soros, who had been long studying the markets, understood the potential for a devaluation and shorted approximately GBP5 bln in the months leading to the big sell-off. Finally, in September 1992, the Italian Lira, which also faced similar issues, was devalued by 7% in early September 1992, to avoid further pressures. In response, German interest rates were cut by 0.25%. The UK government refused a proposal for a devaluation and persisted with keeping the exchange rate fixed at 2.5 DM, and making the situation even more difficult for the Sterling.

As the issues of the UK economy appeared more obvious to traders, pressures increased for the Pound. In response to such moves by Soros and other traders, the UK Treasury reportedly used about GBP1 bln to support the Sterling, by intervening in the FX market, and saw its reserves dry up within a day. On Black Wednesday, September 16, 1992, BoE raised interest rates to 12% but, in Soros’ own words, traders saw this as “an act of desperation”, and an “invitation to double up” on their bets. The GBP19 bln of foreign exchange reserves at BoE, which also started to intervene, started to disappear at the rate of 2 bln per hour as more and more traders shorted. BoE followed standard monetary practice and raised rates to 15% within a few hours after the previous rate hike, an action which was met with little enthusiasm as the Pound continued its drop. In the end, BoE and the UK government threw the towel and admitted defeat, and Black Wednesday ended with the UK withdrawing from the ERM and allowed Sterling to devalue freely. By that time, Soros had increased his bet to approximately 10 billion, gaining a 1 billion Dollar profit as the Pound declined by more than 10%.

What does this tell us? Soros, mainly a macro-fundamental trader, understood the economic dynamics of the ERM and the UK and stuck to his position for months, demonstrating a remarkable commitment to his own opinion. A common argument is that Soros made 1 billion in a day. That is true. But it is also true that he spent months preparing for that day and most likely had to endure losses as the Pound may have often moved against him. Thus, the morale of the story is twofold: understand the fundamentals and stick to your opinion. Success does not come in one day, nor does it come to the unprepared mind.

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Dr Nektarios Michail

Market Analyst


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