When the Unstoppable Force Breaks the Immovable Object
In September 1992, investors short the pound. The Bank of England fights back, but loses. The story of Black Wednesday.
August, 1992
The same 10% interest rate is hitting Britain and Germany very differently: for Britain, it’s acting as a handbrake on an already stagnant economy, contributing to rising unemployment and record high mortgage defaults. For Germany, the rate is well calibrated, as the country is still experiencing robust growth after reunification and needs to rein in inflation. This divergence leaves investors asking a fundamental question: how long can a stagnant Britain keep pace with German interest rates? What happens when those rates inevitably start decoupling? The logical answer is a swift depreciation of the pound. But that cannot happen, or at least in theory, as it has been pegged to the mark since October 1990.
At the time, Britain’s entry into the Exchange Rate Mechanism – a system of fixed exchange rates anchored around the German mark – was seen as the solution to Britain’s inflation problem. After all, the Bundesbank had a track record of successfully delivering low and stable inflation while also achieving solid growth. But, among other things, Britain let national pride get in the way and pegged the pound at a rate which was too high. From the start, instead of trading at the central rate, the pound drifted closer to the bottom of the range it was allowed to trade in. If the pound were to reach this lower band, also called the floor, the Bank of England would have to start buying its own currency to prevent it from breaking lower.
In the mid-August heat of 1992, Stanley Druckenmiller, a portfolio manager at Quantum Fund, is among the few investors who start taking advantage of the structural vulnerability of this exchange rate system. Because the Bank of England is obliged to buy the pound at the floor, he can sell large quantities of it at the same known price. The risk is limited to the cost of holding the position, while the reward, if the peg breaks, can be very high. And with enough sellers, the Bank will eventually run out of foreign reserves it needs to defend the peg.
A few weeks later, while Druckenmiller is building the short from New York, his partner and mentor George Soros flies to Basel for a regular gathering of central bank governors. He, like many other fund managers, is eager to hear from Bundesbank President Helmut Schlesinger.
“Investors are making a mistake if they think the European Currency Unit is a fixed basket of currencies”, the President says at the conclusion of his talk. In other words, Germany has no intention of sacrificing its own price stability to rescue its neighbours’ currencies. These are the exact words Soros and other investors wanted to hear: a green light to keep selling the pound.
A few days later, the Italian lira comes under heavy selling pressure. Germany intervenes, spends billions trying to prop it up, but the selling continues. The Bundesbank and the German finance ministry agree privately that enough is enough, and they cut the rope. The lira devalues 7% in what is telegraphed as an orderly realignment. From Wall Street to the City of London markets watch as the Exchange Rate Mechanism begins to fracture, leaving the pound completely exposed. All the market needs is a final straw.
On the evening of September 15th, an explosive, unauthorized interview given by Schlesinger hits the wires. He calls for a broader realignment of European currencies, without mentioning the pound. But there is no need, the message is loud and clear. Panic spreads within the Bank of England. Its Governor rings Schlesinger, who, after a brief exchange, reaffirms the remarks were never authorised and he promises to issue a clarifying statement in the morning. Disaster, it seems, has been averted.
Back in New York, the sun has just set, and Druckenmiller is still in his office staring at the text of Schlesinger’s interview. The German central bank has signalled to the entire world that it will not defend the pound. He marches into Soros’ office saying the thesis has been validated, the fuse has been lit, and now is the time to continue adding to the short. Soros listens, then looks at his protégé with a cold and resolute expression. “Go for the jugular”, he says, in the deep, firm tone of a general who has been in many battles.
Through the night, Soros and Druckenmiller ring traders at Citi, JP Morgan, Bankers Trust, asking for quotes in the pound and for more leverage so they can keep selling. Market makers, seeing the avalanche of selling from Soros and other funds who have joined in, quickly rush to sell what they have just traded.
When London wakes up, it’s chaos. From the first minutes of trading, the pound is hit by a wall of selling. Corporate treasurers at multinational firms lead the charge, frantically dumping pounds to insulate their balance sheets from a large devaluation. The pound briefly deviates lower from the peg before the Bank executes two £300 million buying orders. The chief dealer, Jim Trott, orders to buy more, but the pound remains at the floor of its corridor. He waits for the cavalry, the Bundesbank, to show up. “We kept on looking over the hill, but there was no dust and there were no hats and no sabres”, he reflects years later.
By mid-morning, the panic is absolute. In an attempt to shock the market and halt the selling, the Treasury announces a 200 basis point rate hike. It’s a savage move considering the state of the British economy, but even that doesn’t help. Trott then calls the Bundesbank asking for a large coordinated intervention to save the peg. Midway through the conversation, officials on the other end of the line start speaking among themselves in German, as if he isn’t there. With the same coldness they cut the lira loose three days earlier, they now do the same with the pound. In that agonizing moment, Trott realizes he is completely alone.
In the early afternoon, in a final, desperate act, the Treasury announces an additional 300 basis points hike to take effect the next day, bringing rates to 15%. But the pound remains at the floor, the market smells blood and continues pressing harder. Druckenmiller and Soros’ position is increased further to $10 billion, sensing that the Bank will soon capitulate.
Finally, at 4pm, when it’s time to pass the bid to the Fed who will cover for the night session, the Bank says “I don’t pay”. It throws in the towel. The pound, which has been trading at, or just below, the floor all day, finally breaks loose. Investors who have shorted the pound have won, they have just broken the peg.
A few hours later, the Chancellor steps out of the Treasury to stand in front of flashing cameras and a sea of reporters. “Today has been an extremely difficult and turbulent day,” he starts. Then continues, “the Government has concluded that Britain’s best interests are served by suspending our membership of the Exchange Rate Mechanism.”
In the weeks that follow, Soros and Druckenmiller reduce their short, while the pound depreciates 15% against the mark. The trade, which is estimated to have made $1 billion for Soros, earns him the nickname that still defines him: the man who broke the Bank of England.
For the British economy, the events later defined as “Black Wednesday” lead to something unexpected: it begins to recover. Rates are cut again and again, the housing markets recovers, while the much feared increase in inflation never materialises. Britain replaces the fixed exchange rate with an inflation targeting mandate. Within five years, the country that crashed out of the Exchange Rate Mechanism is growing faster than Germany and France who are still in it.
History remembers Soros’ genius. However, what history tends to forget is that it was a collective effort that ultimately broke the peg and that there were many other funds which were short in size.
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