Power of Fundamental Analysis: George Soros and the Bank of England

2018-02-01 14:26    forextraders

Fundamental analysis examines the reasons behind the price action. The analyst uses economic indicators and news flows to decide on the causes behind price movements. Since one cannot determine the cause of something which has not yet happened, the causal relationships demonstrated by fundamental analysis are always about present market behavior. Nonetheless, economic events move slower than market developments, and this is the real cause of the great predictive and interpretative power of fundamental analysis.

Fundamental analysis is really old compared to technical analysis

Technical analysis is a relatively new phenomenon. It has been developed mostly in the last century, for the most part by US-based traders, for providing some clarity to short term price actions. Fundamental analysis, on the other hand, has been with us for many centuries. The ancient speculator of the Peloponnesian War in Classical Greece used news flow (hearsay, public meetings) and economic data on supply and demand (starvation, poor harvest) for stockpiling resources and for deciding when to sell them. The ancient Chinese classic Shiji, which records the lives and exploits of important personages two millennia before our time, reports on successful traders and speculators who traded wartime shortages, or the needs of warlords for massive profits. Some of these people were middlemen who exploited the inefficiencies of ancient markets, others were producers themselves with good insight into macro-scale developments, and patience allowed them to successfully utilize their analytical capabilities. But all of them used news and analysis to profit from fundamental developments, without any tool other than common sense to help them.

During the Middle Ages there were the Fugger and the Medici families who took advantage of their good relationships with royalty and governments to stay one step ahead of the markets. The Rotschild family of the 18th-19th centuries also used fundamental imbalances created by warfare to undertake contracts with sovereigns states and for maximizing profits. The twentieth century, of course, has had more than its fair share of traders and speculators capitalizing on market distortions, imbalances and bubbles for very large profits. But at the basic level, the tools of the successful investor, trader or speculator are the same: a good understanding of fundamental data, deaf ears to hyperbole, euphoria and panic, and the strength of will to act when the time is right.

Most transactions and price movements are based on fundamental data

Human life and natural phenomena move on causal relationships. Causality is a major principle of scientific study. And, given how our brains function, it is not possible to make any meaningful decision, judgment or choice without backing it with sensible causes. This is also where the power of fundamental analysis originates. The charts of the technical analyst may give all kinds of profit alerts, signals and alarms, but there's little in the charts that tell us why a group of people make the choices that create the price patterns. Ultimately, most transactions in the financial markets have reasons that are independent of technical values in the long-term. If a stock goes down in response to a temporary bout of panic among traders, the price will rebound once the dust settles; or, if a currency pair plummets in value because of a false rumor or a temporary squeeze of capital, the situation will inevitably be corrected once a stream of concrete data establishes the false nature of the fears.

Fundamental analysis allows us to decide on the value of an asset

We are unable to be certain about the future value of an asset, and past value is never a good indicator for future prices. But, by all means, we posses the faculties and resources necessary for deciding if the price of an asset is expensive or not, and that is the basis on which the fundamental analyst bases his choices. We can establish the causes behind a trend, we can establish if they are ongoing, and we can exploit that knowledge to bring us profits.

George Soros in action winning against the British pound based on fundamentals

There are many traders who successfully used fundamental analysis to obtain great wealth, but the exploits of George Soros, and his Quantum Hedge Fund have made them household names in our era, particularly after the notorious Black Wednesday on which Britain was forced to drop out of the European exchange rate mechanism. In the rest of this article we will examine this interesting event to drive home the great power of fundamental analysis and how accurate and profitable its predictions can be.

The British pound is not part of the Euro system because of the events in September 1992

Most traders today know that the British pound is not a part of the Eurosystem. It is an independent currency managed by its own central bank. While some may attribute this fact to the insular mentality of the British and their typical desire for independence from continental customs and habits, this is not the real cause of the existence of the pound today. The real reasons are to be found in the developments of September 16th 1992, and the events leading up to them.

Britain joined the ECU in 1990

Before it was launched, the nations which today share the Euro as their national currency had to abide by an agreement known as the European Exchange rate mechanism (ERM) which was the precursor to the eventual unification of currencies. The ERM stipulated a fixed currency exchange rate between each national currency and the ECU (the European currency unit, which would eventually be called the Euro), but bilateral currency values were allowed to float within a margin of 2.25 of the the fixed rate. The ERM was created in 1979, and Britain was one of the later members of the EU to join the mechanism in 1990.

At the time Britain joined, the government of Margaret Thatcher was lost in intrigues and disputes about the benefits and the need for ERM. With inflation at 15 percent, to restrain the expansionism of the previous era, the British government had for a while been mirroring the Bundesbank's policy rates. The decision to join was partly taken to formalize this policy of copying the central bank rates of Western Germany, and also as a result of an argument between the chancellor of the exchequer (the equivalent of the Treasury secretary), Nigel Lawson and the prime minister's economic advisor, which resulted in the resignation of Lawson. He was replaced by the future prime minister John Major, who in turn finalized the entry of Britain into the ERM in 1990 at a rate of 2.95DM to the pound, with commitment to intervene at 2.778.

British inflation was high at the time of entry

As we just mentioned, at the time of Britain's entry, inflation was quite high, due to the expansionist policies of Nigel Lawson. The easy money policy had created a period of boom at the end of the 80's, but it had also created a property bubble and high inflation which had to be restrained by higher interest rates and a period of economic downturn. Thus, when the crisis struck two years after UK's adoption of the ERM, economic conditions were already far from being ideal. Unfortunately for the British, this was also a time when German interest rates were even higher than the British rates, as the Bundesbank tried to control the inflationary impact of reunification-related spending.

About George Soros

Mr. Soros, who enters the scene at about this point, had established his Quantum Fund in the early 1970s in partnership with the equally famous Jim Rogers, his initial capital being provided by a number of wealthy acquaintances including the aforementioned Rotschild family. Before his rise to notoriety through his role in the British debacle, he had already made massive profits in trading the collapse of currency pegs and economic deregulation of the 70s. He and his analysts had impressive skills in analyzing the fundamental factors that drive the international economy. Indeed, apart from being a rich financier, Mr. Soros has books published on philosophy and politics, and he is equally well-known as a philanthropist and for his contributions to liberal movements around the world.

George Soros starts speclating in the British pound based on fundamentals

Upon analyzing the fundamental situation of the British economy and the increasing gap between the performance of the British and German economies at the time of Britain's adoption of the ERM, Mr. Soros was increasingly convinced that the British would drop out of the system regardless of the choices they made. The fundamental health of the UK economy was incapable of coping with the demands of matching Germany at the time. Thus, he began shorting the pound as early as spring 1992, in anticipation that high interest rates would eventually deepen the recession in the UK economy, and the resulting fall of asset prices would prove unpalatable to the government authorities. It is thought that he accumulated short positions reaching 6.5 billion pounds (about 10 billion USD), at a leverage of 1:10.

Political turmoil gives the breaking point

Meanwhile, the situation of Britain continued to deteriorate as the USD kept depreciating, making British exports less competitive on a global basis. The breaking point came, as it often happens, through political turmoil. When in spring 1992 the Danes refused to join the ERM, and it was decided that France would have a referendum on the issue as well, the resulting nervous atmosphere reached climax in a general distrust of the currency pegs of nations that were suffering the worst of the ERM.

Britain fights in vain for its currency

On Wednesday, 16th September 1992, as speculators kept selling the pound, the British cabinet held meeting after meeting on how to defend the nation's currency. They first raised the main rate to 10, then to 12, eventually promised to raise to 15 percent in order to convince the speculators that they were facing the full determination and might of the UK government. The government also bought billions of pounds to prop up the currency, but all that was in vain. Heedless monetary expansionism of the Lawson Boom had created massive imbalances in the British financial system, and the British economy would never be able to function under such a high interest rate burden. Speculators like George Soros had already made their calculations and had discovered the untenable nature of the British peg a long time ago through fundamental analysis, and they would not be cowed into submission by the frantic, but ultimately futile endeavors of the John Major Government.

George Soros was the man who broke the Bank of England

By 19:00 it was already clear that the peg couldn't be defended, and the Chancellor of the Exchequer had to declare that the government would leave the ERM framework, and the main interest rate would remain at 12 percent. The credibility of the British government was destroyed in a few hours, the speculators left for new hunts, and George Soros pocketed an estimated 1 billion USD in the process. As the person who took the largest bet, he was instantly notorious across the globe, and to this day he's known as “the man who broke the Bank of England”.

Later, it was also admitted that the 15 percent promise was just a ruse created to calm the markets, and as many speculators believed, the government had no intention of holding the rates at such a high level given the difficulties the British economy were going through.

What lessons can we learn from this?

It is an exciting story, but the sensational value of the events has no use for our trading practices. What are the lessons that we gain from this disaster for the UK economy?

  1. Fundamental analysis is always right. Imbalances will always be corrected. But it takes time and patience to exploit them successfully. Mr. Soros held his position for months before market developments confirmed his expectations.

  2. Neither government authorities, nor company heads are immune to the temptation of lying, or “bluffing” as it's sometimes called. If you're a speculator, nobody will have any sympathy for you if you lose money, and the only person you can blame is yourself. So be careful about your leverage, your risk and who you believe.

  3. Macroeconomic events are often triggered by political developments. Political events rarely cause major economic shocks by themselves alone, but accumulated imbalances are usually balanced as a result of political shocks.

  4. The payback time of expansion fueled by monetary expansionism is exceptionally destructive in any economy. If the economic leadership of a nation is constrained by political obstacles when the payback time arrives, the results are doubly disastrous.

If you intend to use fundamental analysis in the way George Soros used it, you will need a good understanding of both politics and economics. Achieving such a skill is not that hard, provided you have the commitment and the patience to complete your task.

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