In 1992, George Soros made one of the most legendary trades of all time: a substantial bet that the British Pound would plummet in value. In hindsight, the trade looks like a no brainer (similar to how shorting the 2008 housing market looks today). How did everyone not see that? It was inevitable.
But Soros went against one of the most pervasive trading axioms of our time. You may have heard "Don't Fight the Fed." The expression refers to the fact that when the Federal Reserve is in the market, you shouldn't bet against it. The Fed moves the market. Trading the Pound, Soros' bet wasn't fighting the Fed, but it was fighting the Bank of England - a similar market force.
So how'd he do it? How did he "break the Bank of England?" And, critically, how did he make $1 billion in a month and catapult himself into trading lore and enable himself to build one of the greatest trading fortunes in history?
It's important to understand the political backdrop of Europe in the early 1990s. Unlike today, the continent was a collection of currencies inside the European Exchange Rate Mechanism (ERM). The goal of Europe's ERM was to establish monetary stability in Europe, in preparation for the European Union and the introduction of the Euro.
Britain first entered the ERM in October 1990, agreeing to keep the British Pound valued between 2.78 and 3.13 German Deutschmarks. The country quickly found itself in an economic recession. In a normal recession, the Bank of England would lower interest rates to prop up the economy. However, lower rates have a negative effect on the relative values of currencies - and if the Bank of England lowered rates, it would make it impossible to maintain the British Pound's value relative to Germany's Deutschmark.
The bank had to choose: would it try to revive economic growth or stay in the European ERM? The Bank of England chose the ERM. Instead of lowering interest rates, the Bank raised them. It also used its foreign currency reservves to buy the Pound as speculators began to sell the currency realizing it was in an economic malaise.
Over the ensuing two years, the U.K. continued to support its currency - a move that cost it billions. But the market believed that Britain would continue to honor its commitment, and that belief alone kept up the house of cards.
But in August 1992, something changed. The German Bundesbank began to float the idea that currencies in the ERM could be revalued, starting with council members and moving to the President of the Bundesbank, Helmut Schlesinger.
Schlesinger's willingness to explore devalutation opened the flood gates and completely changed the risk / reward to a short Pound position. If the Pound didn't devalue, it would still likely stay in the weaker portion of its band. However, if it did weaken, it would be by a substantial amount.
Final Death Blow
When approached with Schlesinger's comments, Soros famously told his head trader, "Go for the jugular." Soros' fund sold $10 billion worth of Pounds short, flooding the market. Other hedge funds piled on board, selling billions more and putting further pressure on the Bank of England.
However, the Bank of England had a couple last gasps in it. It proceeded to raise interest rates by 2%. (Raising interest rates generally leads currencies to appreciate.) When that didn't cause the Pound to rally, the Bank raised interest rates by another 3% the same afternoon. The market didn't react. Everyone kept selling Pounds.
The writing was on the wall - and the last people to realize it were the British central bankers. At 7:30 PM that night, the Bank of England announced that Britain would leave the European ERM and allow its currency to float on the market.
The Pound immediately fell 15% against the Deutschmark - and fell 25% against the U.S. Dollar. Soros' short bet paid off for more than $1 billion, and he cemented himself into trading legends. But unlike Jesse Livermore, who left the crash of 1929 with a net worth of $1.4 billion and was bankrupt five years later, Sorors parlayed his 1992 gains into a net worth of $23 billion, according to Forbes.
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