Breaking the Bank of EnglandThe 1992 trade that started in the economy.
One of the most famous trades in history was built on fundamental analysis. How the 1992 short on the pound was found, step by step, and the method behind it that you can use at any size.
A system built to keep currencies stable
In the early 1990s the United Kingdom was part of the European Exchange Rate Mechanism, the ERM. It was set up before the euro existed, to reduce the swings between European currencies and keep them stable against each other.
Each member currency had to stay inside an agreed band, a narrow range it was not allowed to leave. For the pound, that meant holding its value against the other member currencies, such as the German mark.
Holding a currency inside a band has a cost. When the market pushes it towards the edge, the country has to defend it, by buying its own currency or by making it more attractive to hold with higher interest rates.
Why the band got harder to hold
The UK had a problem. Inflation was high, and the interest rates used to fight it were high too. High rates weigh on an economy, so there was little room to raise them further in defence of the pound. Keeping it inside the band got harder and harder.
George Soros, one of the best-known currency traders of all time, looked at those fundamentals and came to a clear view. The pound was overvalued, and the UK would not be able to keep it inside the band. Sooner or later it would have to devalue the pound, which means lowering its agreed value, or leave the system altogether.
That view rested on inflation, interest rates, the state of the economy and the politics around the ERM. His approach was to assess the economic conditions and the government’s policy, and to look for the point where they no longer fit together.
The trade
In September 1992, Soros’s Quantum Fund began a series of aggressive trades, selling the pound short in huge size. Selling short means selling something you don’t own, so you can buy it back cheaper later. In forex every trade is long one currency and short another, so selling GBP/USD, for example, means you are short the pound against the dollar. The fund was betting that the pound would fall.
Then the UK government announced that it was pulling the pound out of the ERM and letting it float freely. Without the band to hold it, the pound plunged against the German mark and the US dollar. The fund reportedly made more than $1 billion, and the trade became known as breaking the Bank of England.
The band also shaped the risk. While the system held, the pound could only move within its agreed limits, which capped how far it could rise against a short position. If the band broke, there was no such limit on the way down. A possible reward far bigger than the risk is rare, and this trade had one.
The method you can reuse
The key part of this story is how the trade was found. It came from a careful read of the economy, the interest rates, the politics and the pressure building in the system, with no guesswork and no chart pattern involved.
You will not trade in that size, and you do not need to. The method works every week at any size: understand the economic and political picture, find where something does not add up, and let that point you to a direction. Then decide what would prove you wrong before you act on it.
The biggest moves come from fundamentals that stop making sense.
Growth, inflation, interest rates and the politics behind them.
A policy that clashes with the data, or a price that ignores it.
Write it as one sentence: this currency should weaken because…
Decide what would prove the view wrong before you trade it.
Where tensions show up today
Ask what the defence costs the economy and how long it can last. An official policy can look fixed until the day it breaks, as the pound’s band did, and pressure that keeps building is the kind of tension this trade was built on.
A central bank holding rates while inflation keeps rising, or a currency staying strong while its economy weakens, is worth writing down. Big moves can grow out of tensions like these.
In short
- In the early 1990s the pound had to stay inside a narrow band in the ERM, while UK inflation and interest rates were high.
- George Soros judged the pound overvalued and the band impossible to hold. His fund sold the pound short in September 1992, and when the UK left the ERM the pound plunged.
- The trade came from a careful read of the economy, rates and politics. The method works every week, at any size: find what doesn’t add up.
Key terms
- European Exchange Rate Mechanism (ERM)
- A European system, set up before the euro, that kept member currencies inside agreed bands against each other. The UK left it in September 1992.
- Fundamental analysis
- Studying the economy, central banks, politics and money flows to judge where a currency should go and why.
- Short selling
- Selling something you do not own to buy it back cheaper later. In FX every trade is long one currency and short another.
- Inflation
- The rate at which prices rise. Central banks usually aim for about 2% a year.
- Key interest rate
- The rate a central bank sets for lending to banks. It drives borrowing costs across the economy and is one of the biggest drivers of a currency.