Historical Events in the FX Market

Before diving into the inner workings of currency trading, it is important for every trader to understand a few of the key milestones in the foreign exchange marker, since even to this day they still represent events that are referenced repeatedly by professional forex traders.

BRETTON WOODS: ANOINTING THE DOLLAR AS THE WORLD CURRENCY (1944)

In July 1944, representatives of 44 nations met in Bretton Woods, New Hampshire, to create a new institutional arrangement for governing the international economy in the years after World War II. After the war, most agreed that international economic instability was one of the principal causes of the war, and that such instability needed to be prevented in the future. The agreement, which was developed by renowned economists John Maynard Keynes and Harry Dexter White, was initially proposed to Great Britain as a part of the Lend-Lease Act—an American act designed to assist Great Britain in postwar redevelopment efforts. After various negotiations, the final form of the Bretton Woods Agreement consisted of several key points:

1. The formation of key international authorities designed to promote fair trade and international economic harmony.

2. The fixing of exchange rates among currencies.

3. The convertibility between gold and the U.S. dollar, thus empowering the U.S. dollar as the reserve currency of choice for the world.

Of the three aforementioned parameters, only the first point is still in existence today. The organizations formed as a direct result of Bretton Woods include the International Monetary Fund (IMF), World Bank, and General Agreement on Tariffs and Trade (GATT), which are still in existence today and play a crucial role in the development and regulation of international economies. The IMF, for instance, initially enforced the price of $35 per ounce of gold that was to be fixed under the Bretton Woods system, as well as the fixing of exchange rates that occurred while Bretton Woods was in operation (and the financing required to ensure that fixed exchange rates would not create fundamental distortions in the international economy).

Since the demise of Bretton Woods, the IMF has worked closely with another progeny of Bretton Woods: the World Bank. Together, the two institutions now regularly lend funds to developing nations, thus assisting them in the development of a public infrastructure capable of supporting a sound mercantile economy that can contribute in an international arena. And, in order to ensure that these nations can actually enjoy equal and legitimate access to trade with their industrialized counterparts, the World Bank and IMF must work closely with GATT. While GATT was initially meant to be a temporary organization, it now operates to encourage the dismantling of trade barriers—namely tariffs and quotas.

The Bretton Woods Agreement was in operation from 1944 to 1971 when it was replaced with the Smithsonian Agreement, an international contract of sorts pioneered by U.S. President Richard Nixon out of the necessity to accommodate for Bretton Woods' shortcomings, unfortunately, the Smithsonian Agreement possessed the same critical weakness: while it did not include gold/U.S. dollar convertibility, it did maintain fixed exchange rates—a facet that did not accommodate the ongoing U.S. trade deficit and the international need for a weaker U.S. dollar. As a result, the Smithsonian Agreement was short-lived.

Ultimately, the exchange rates of the world evolved into a free market, whereby supply and demand were the sole criteria that determined the value of a currency. While this did and still does result in a number of currency crises and greater volatility between currencies, it also allowed the market to become self-regulating, and thus the market could dictate the appropriate value of a currency without any hindrances.

As for Bretton Woods, perhaps its most memorable contribution to the international economic arena was its role in changing the perception regarding the U.S. dollar. While the British pound is still substantially stronger, and while the euro is a revolutionary currency blazing new frontiers in both social behavior and international trade, the U.S dollar remains the world's reserve currency of choice, for the time being. This is undeniably due lately in part to the Bretton Woods Agreement: by establishing dollar/gold convertibility, the dollars role as the world's most accessible and reliable currency was firmly cemented. And thus, while Bretton Woods may be a doctrine of yesteryear, its impact on the U.S. dollar and international economics still resonates today.

END OF BRETTON WOODS: FREE MARKET CAPITALISM IS BORN (1971)

On August 15, 1971, it became official: the Bretton Woods system, a system used to fix the value of a currency to the value of gold, was abandoned once and for all. While it had been exorcised before, only to subsequently emerge in a new form, this final eradication of the Bretton Woods system was truly its last stand: no longer would currencies be fixed in value to gold, allowed to fluctuate only in a 1 percent range, but instead their fair valuation could be determined by free market behavior such as trade flows and foreign direct investment.

While U.S. President Nixon was confident that the end of the Bretton Woods system would bring about better times for the international economy, he was not a believer that the free market could dictate a currency's true valuation in a fair and catastrophe-free manner. Nixon, as well as most economists, reasoned that an entirely unstructured foreign exchange market would result in competing devaluations, which in turn would lead to the breakdown of international trade and investment. The end result, Nixon and his board of economic advisers reasoned, would be global depression.

Accordingly, a few months later, the Smithsonian Agreement was introduced. Hailed by President Nixon as the "greatest monetary agreement in the history of the world," the Smithsonian Agreement strived to maintain fixed exchange rates, but to do so without the backing of gold. Its key difference from the Bretton Woods system was that the value of the dollar could float in a range of 2.25 percent, as opposed to just 1 percent under Bretton Woods.

Ultimately, the Smithsonian Agreement proved to be unfeasible as well. Without exchange rates fixed to gold, the free market gold price shot up to $215 per ounce. Moreover, the U.S. trade deficit continued to grow, and from a fundamental standpoint, the U.S. dollar needed to be devalued beyond the 2.25 percent parameters established by the Smithsonian Agreement. In light of these problems the foreign exchange markets were forced to close in February 1972.

The forex markets reopened in March 1973, and this time they were not bound by a Smithsonian Agreement: the value of the U.S. dollar was to be determined entirely by the market, as its value was not fixed to any commodity, nor was its exchange rate fluctuation confined to certain parametric. While this did provide the U.S. dollar, and other currencies by default, the agility required to adapt to a new and rapidly evoking international trading environment, it also set the stage for unprecedented inflation. The end of Bretton Woods and the Smithsonian Agreement, as well as conflicts in the Middle East resulting in substantially higher oil prices, helped to create stagflation—the synthesis of unemployment and inflation—in the U.S. economy. It would not be until later in the decade, when Federal Reserve Chairman Paul Volcker initiated new economic policies and President Ronald Reagan introduced a new fiscal agenda, that the U.S. dollar would return to normal valuations. And by then, the foreign exchange markets had thoroughly developed, and were now capable of serving a multitude of purposes: in addition to employing a laissez-faire style of regulation for international trade, they also were beginning to attract speculators seeking to participate in a market with unrivaled liquidity and continued growth. Ultimately, the death of Bretton Woods in 1971 marked the beginning of a new economic era, one that liberated international trading while also proliferating speculative opportunities.

PLAZA ACCORD—DEVALUATION OF U.S. DOLLAR (198S)

After the demise of all the various exchange rate regulatory mechanisms that characterized the twentieth century—the gold standard, the Bretton Woods standard, and the Smithsonian Agreement—the currency market was left with virtually no regulation other than the mythical "invisible hand" of free market capitalism, one that supposedly strived to create economic balance through supply and demand. Unfortunately, due to a number of unforeseen economic events—such as the Organization of Petroleum Exporting Countries (OPEC) oil crises, stagflation throughout the 1970s, and drastic changes in the U.S. Federal Reserve's fiscal policy—supply and demand, in and of themselves, became insufficient means by which the currency markets could be regulated. A system of sorts was needed, but not one that was inflexible. Fixation of currency values to a commodity, such as gold, proved to be too rigid for economic development, as was also the notion of fixing maximum exchange rate fluctuations. The balance between structure and rigidity was cute that had plagued the currency markets throughout the twentieth century, and while advancements had been made, a definitive solution was still greatly needed.

And hence in 1985, the respective ministers of finance and central bank governors of the world's leading economies—France, Germany. Japan, the United Kingdom, and the United Slates—convened in New York City with the hopes of arranging a diplomatic agreement of sorts that would work to optimize the economic effectiveness of the foreign exchange markets. Meeting at the Plaza Hotel, the international leaders came to certain agreements regarding specific economies and the international economy as a whole.

Across the world, inflation was at very low levels. In contrast to the stagflation of the 1970s where inflation was high and real economic growth was low—the global economy in 1985 had done a complete 180-degree turn, as inflation was now low but growth was strong.

While low inflation, even when coupled with robust economic growth, still allowed for low interest rates—a circumstance developing countries particularly enjoyed—there was an imminent danger of protectionist policies like tariffs entering the economy. The United States was experiencing a large and growing current account deficit, while Japan and Germany were facing large and growing surpluses. An imbalance so fundamental in nature could create serious economic disequilibrium, which in turn would result in a distortion of the foreign exchange markets and thus the international economy.

The results of current account imbalances, and the protectionist policies that ensued, required action. Ultimately, it was believed that the rapid acceleration in the value of the U.S. dollar, which appreciated more than 80 percent against the currencies of its major trading partners, was the primary culprit. The rising value of the U.S. dollar helped to create enormous trade deficits. A dollar with a lower valuation, on the other hand, would be more conducive to stabilizing the international economy, as if would naturally bring about a greater balance between the exporting and importing capabilities of all countries.

At the meeting in the Plaza Hotel, the United States persuaded the other attendees to coordinate a multilateral intervention, and on September 22, 1985, the Plaza Accord was implemented. This agreement was designed to allow for a controlled decline of the dollar and the appreciation of the main antidollar currencies. Each country agreed to changes to its economic policies and to intervene in currency markets as necessary to gel the dollar down. The United Slates agreed to cut its budget deficit and to lower interest rates. France, the United Kingdom, Germany, and Japan all agreed to raise interest rates, Germany also agreed to institute tax cuts while Japan agreed to let the value of the yen "fully reflect the underlying strength of the Japanese economy." However, the problem with the actual implementation of the Plaza Accord was that not every country adhered to its pledges. The United Stales in particular did not follow through with its initial promise to cut the budget deficit. Japan was severely hurt by the sharp rise in the yen, and its exporters were unable to remain competitive overseas, and it is argued that this eventually triggered a 10-year recession in Japan. The United Slates, in contrast, enjoyed considerable growth and price stability as a result of the agreement.

The effects of the multilateral intervention were seen immediately, and within two years the dollar had fallen 46 percent and 50 percent against the deutsche mark (DEM) and the Japanese yen (JPY), respectively. Figure 2-1 shows this depreciation of the U.S. dollar against the DEM and the JPY. The U.S. economy became far more export-oriented as a result, while other industrial countries like Germany and Japan assumed the role of importing. This gradually resolved the current account deficits for the time being, and also ensured that protectionist policies were minimal and nonthreatening. But perhaps most importantly, the Plaza Accord cemented the role of the central banks in regulating exchange rate movement: yes, the rates would not be fixed, and hence would be determined primarily by supply and demand; but ultimately, such an invisible hand is insufficient, and it was the right and responsibility of the worlds central banks to intervene on behalf of the international economy when necessary.

Plaza Accord Price Action hi o

Figure 2.1 Plaza Accord Price Action

Figure 2.1 Plaza Accord Price Action

GEORGE SOROS—THE MAN WHO BROKE THE BANK OF ENGLAND

When George Soros placed a $10 billion speculative bet against the U.K. pound and won, he became universally known as "the man who broke the Bank of England." Whether you love him or hate him, Soros led the charge in one of the most fascinating events in currency trading history.

The United Kingdom Joins the Exchange Rate Mechanism

In 1979, a Franco-German initiative set up the European Monetary System (EMS) in order to stabilize exchange rates, reduce inflation, and prepare for monetary integration. The Exchange Rate Mechanism (ERM), one of the EMS's main components, gave each participatory currency a central exchange rate against a basket of currencies, the European Currency Unit (ECU). Participants (initially France, Germany, Italy, the Netherlands, Belgium, Denmark, Ireland, and Luxembourg) were then required to maintain their exchange rates within a 2.25 percent fluctuation band above or below each bilateral central rate. The ERM was an adjustable-peg system, and nine realignments would occur between 1979 and 1985.

While the United Kingdom was not one of the original members, it would eventually join in 1990 at a rate of 2.95 deutsche marks to the pound and with a fluctuation band of +/- 6 percent.

Until mid-1992, the ERM appeared to be a success, as a disciplinary effect had reduced inflation throughout Europe under the leadership of the German Bundesbank. The stability wouldn't last, however, as international investors started worrying that the exchange rate values of several currencies within the ERM were inappropriate. Following German reunification in 1989, the nation's government spending surged, forcing the Bundesbank to print more money. This led to higher inflation and left the German central hank with little choice but to increase interest rates. But the rate hike had additional repercussions—because it placed upward pressure on the German mark. This forced other central banks to raise their interest rates as well, so as to maintain the pegged currency exchange rates (a direct application of Irving Fishers interest rate parity theory). Realizing that the United Kingdom's weak economy and high unemployment rate would not permit the British government to maintain this policy for long, George Soros stepped into action.

Soros Bets Against Success of U.K. Involvement in ERM

The Quantum hedge fund manager essentially wanted to bet that the pound would depreciate because the United Kingdom would either devalue the pound or leave the ERM. Thanks to the progressive removal of capital controls during the EMS years, international investors at the time had more freedom than ever to take advantage of perceived disequilibriums, so Soros established short positions in pounds and long positions in marks by borrowing pounds and investing in mark-denominated assets. He also made great use of options and futures. In all, his positions accounted for a gargantuan $10 billion. Soros was not the only one: many other investors soon followed suit. Everyone was selling pounds, placing tremendous downward pressure on the currency.

At first, the Bank of England tried to defend the pegged rates by buying 15 billion pounds with its large reserve assets, but its sterilized interventions (whereby the monetary base is held constant thanks to open market interventions) were limited in their effectiveness. The pound was trading dangerously close to the lower levels of its fixed band. On September 16, 1992, a day that would later be known as Black Wednesday, the bank announced a 2 percent rise in interest rates (from 10 percent to 12 percent) in an attempt to boost the pound's appeal. A few hours later, it promised to raise rates again, to 15 percent, but international investors such as Soros could not be swayed, knowing that huge profits were right around the corner. Traders kept selling pounds in huge volumes, and the Bank of England kept buying them until, finally, at 7:00 p.m. that same day, Chancellor Norman Lamont announced Britain would leave the ERM and that rates would return to their initial level of 10 percent. The chaotic Black Wednesday marked the beginning of a steep depreciation in the pounds effective value.

Whether the return to a floating currency was due to the Soros-led attack on the pound or because of simple fundamental analysis is still debated today. What is certain, however is that the pound's depreciation of almost 15 percent against the deutsche mark and 25 percent against the dollar over the next five weeks (as seen in

Figure 2.2 and Figure 2.3) resulted in tremendous profits for Soros and other traders. Within a month, the Quantum Fund rushed in on approximately $2 billion by selling the now more expensive deutsche marks and buying back the now cheaper pounds. "The man who broke the Bank of England" showed how central banks can still be vulnerable to speculative attacks.

British Pound Against Deutsche Marie (GBP/DEM)

British Pound Against Deutsche Marie (GBP/DEM)

Figure 2.2 GBP/DEM After Soros

Brilish Pound Against U.S. Dollar (G8P/USD)

Brilish Pound Against U.S. Dollar (G8P/USD)

Figure 2.3 GBP/USD After Soros

ASIAN FINANCIAL CRISIS (1997-1998)

Falling like a set of dominos on July 2, 1997, the relatively nascent Asian tiger economies created a perfect example in showing the interdependence of global capital markets and their subsequent effects throughout international currency forums. Based on several fundamental breakdowns, the cause of the contagion stemmed largely from shrouded lending practices, inflated trade deficits, mid immature capital markets. Added together, the factors contributed to a "perfect storm" that left major regional markets incapacitated and once-prized currencies devalued to significantly lower levels. With adverse effects easily seen in the equities markets, currency market fluctuations were negatively impacted in much the same manner during this time period.

The Bubble

Leading up to 1997, investors had become increasingly attracted to Asian investment prospects, focusing on real estate development and domestic equities. As a result, foreign investment capital flowed into the region as economic growth rates climbed on improved production in countries like Malaysia, the Philippines, Indonesia, and South Korea. Thailand, home of the baht, experienced a 13 percent growth rate in 1988 (falling to 6.5 percent in 1996). Additional lending support for a stronger economy came from the enactment of a fixed currency peg to the more formidable U.S. dollar. With a fixed valuation to the greenback countries like Thailand could ensure financial stability in their own markets and a constant rate for export trading purposes with the world's latest economy. Ultimately, the regions national currencies appreciated as underlying fundamentals were justified, and speculative positions in expectation of further climbs in price mounted.

Ballooning Current Account Deficits and Nonperforming Loans

However, in early 1997, a shift in sentiment had begun to occur as international account deficits became increasingly difficult for respective governments to handle and lending practices were revealed to be detrimental to the economic infrastructure. In particular, economists were alerted to the fact that Thailand's current account deficit had ballooned in 1996 to $14.7 billion (it had been climbing since 1992). Although comparatively smaller than the U.S. deficit, the gap represented 8 percent of the country's gross domestic product. Shrouded lending practices also contributed heavily to these breakdowns as close personal relationships of borrowers with highranking banking officials were well rewarded and surprisingly common throughout the region. This aspect affected many of South Korea's highly leveraged conglomerates as total nonperforming loan values sky-rocketed to 7.5 percent of gross domestic product.

Additional evidence of these practices could be observed in financial institutions throughout Japan. After announcing a $136 billion total in questionable and nonperforming loans in 1994, Japanese authorities admitted to an alarming $400 billion total a year later. Coupled with a then crippled stock market, cooling real estate values, and dramatic slowdowns in the economy, investors saw opportunity in a depreciating yen. subsequently adding selling pressure to neighbor currencies. When Japan's asset bubble collapsed, asset prices fell by $10 trillion, with the fall in real estate prices accounting for nearly 65 percent of the total decline, which was worth two years of national output. This fall in asset prices sparked the banking crisis in Japan. It began in the early 1990s and then developed into a full-blown systemic crisis in 1997 following the failure of a number of high-profile financial institutions. In response, Japanese monetary authorities warned of potentially increasing benchmark interest rates in hopes of defending the domestic currency valuation.

Unfortunately, these considerations never materialized and a shortfall ensued. Sparked mainly by an announcement of a managed float of the Thai baht, the slide snowballed as central bank reserves evaporated and currency price levels became unsustainable in light of downside selling pressure.

Currency Crisis

Following mass short speculation and attempted intervention, the aforementioned Asian economies were left ruined and momentarily incapacitated. The Thailand baht, once a prized possession, was devalued by as much as 48 percent, even slumping closer to a 100 percent fall at the turn of the New Year. The most adversely affected was the Indonesian rupiah. Relatively stable prior to the onset of a "crawling peg" with the Thai baht, the rupiah fell a whopping 228 percent from its previous high of 12,950 to the fixed U.S. dollar. These particularly volatile price actions are reflected in Figure 2.4. Among the majors, the Japanese yen fell approximately 23 percent from its high to its low against the U.S. dollar in 1997 and 1998, its shown in Figure 2.5.

1997-1998 A»ian Currency Fluctuations 60 t HOOO

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