Chapter 2
Historical Events in the FX Markets

Before learning how to trade currencies, it is important for every new and seasoned market participant to have some understanding about the most important historical events that have shaped the currency market. To this day, these events are often referenced by professional 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 following World War II. Most agreed that international economic instability was one of the principle 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 three key items:

1. The formation of key international authorities designed to promote fair trade and international economic harmony
2. The fixation of exchange rates between 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 these three parameters, only the first is still in existence today, but 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); and they all play a crucial role in modern day development and regulation of international economies. Since the demise of Bretton Woods, the IMF has worked closely with the World Bank. Together, the two institutions now regularly lend funds to developing nations, assisting them in the development of a public infrastructure capable of supporting a sound mercantile economy that can contribute in the international arena. 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 existed from 1944 to 1971, after which it was replaced by the Smithsonian Agreement, an international contract pioneered by U.S. President Richard Nixon out 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 maintained fixed exchange rates—a facet that did not accommodate the United States' ongoing 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, where 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 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 international perception about the U.S. dollar. 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. This is due, in large part, to the Bretton Woods Agreement: By establishing dollar/gold convertibility, the dollar's role as the world's most accessible and reliable currency was firmly cemented. So while Bretton Woods might be a doctrine of yesteryear, its impact on the U.S. dollar and international economics still resonates today.

The End of Bretton Woods: Free Market Capitalism Is Born (1971)

On August 15, 1971, it became official: The Bretton-Woods system 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 only to fluctuate in a 1% range, but instead, their fair valuation could be determined by free-market behavior such as trade flows and foreign direct investment.

Although 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 and many well-respected economists at the time 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 advisors argued, would be global depression.

In response, the Smithsonian Agreement was introduced a few months later. Hailed by President Nixon as the “greatest monetary agreement in the history of the world,” the Smithsonian Agreement strived to maintain fixed exchange rates 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%, compared to just 1% 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% parameters established by the Smithsonian Agreement. In light of these problems, the foreign exchange markets were forced to close in February 1972.

The markets reopened in March 1973, and this time, they were not bound by a Smithsonian Agreement: The value of the US 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 parameters. While this did provide the U.S. dollar, and other currencies by default, the agility required to adapt to a new and rapidly evolving 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, resulted in substantially higher oil prices and 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 Reagan introduced a new fiscal agenda, that the U.S. dollar would return to “normal” valuations. By then, the foreign exchange markets had thoroughly developed and were capable of serving a multitude of purposes. In addition to employing a laissez-faire style of regulation on 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 the U.S. Dollar (1985)

After the demise of all the various exchange rate regulatory mechanisms that characterized the twentieth century—that is, 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 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 one that had plagued the currency markets throughout the twentieth century, and while advancements had been made, a definitive solution was still greatly needed.

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 States—convened in New York City, with the hopes of arranging a diplomatic agreement that would work to optimize the economic effectiveness of the foreign exchange markets. Meeting at the Plaza Hotel, the international leaders came to the following agreements regarding specific economies and the international economy as a whole:

• Across the world, inflation was at very low levels. Contrary 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, as inflation was now low and growth was strong.
• While low inflation, even when coupled with robust economic growth, still allowed for low interest rates—a caveat that developing countries particularly enjoyed—there was an imminent danger of protectionist policies such as 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 as a whole.
• 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% against the currencies of its major trading partners, was the primary culprit. The rising value of the U.S. dollar created enormous trade deficits, hurting many different economies.

At the meeting in the Plaza Hotel, the United States persuaded other attending countries 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 anti-dollar currencies. Each country agreed to changes to their economic policies and to intervene in currency markets as necessary to weaken the value of the dollar. The United States agreed to cut its budget deficit and lower interest rates. France, the United Kingdom, Germany, and Japan agreed to raise interest rates. Germany also agreed to tax cuts, while Japan agreed to let the value of the yen “fully reflect the underlying strength of the Japanese economy.” However, one major problem was that not every country adhered to their pledges made under the Plaza Accord. The United States, 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, as its exporters were unable to remain competitive overseas, and it is argued that this eventually triggered a 10-year recession in Japan. The United States, on the other hand, enjoyed considerable growth and price stability as a result of the agreement.

The effects of the multilateral intervention were seen immediately, and within less than two years, the dollar fell 46% and 50% against the German deutschemark and the Japanese yen, respectively, as shown in Figure 2.1. The U.S. economy became far more export-oriented as a result, while other industrial countries like Germany and Japan assumed the role of major net importers. 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 world's central banks to intervene on behalf of the international economy when necessary.

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 on the UK 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. Here are the details.

The UK Joins the Exchange Rate Mechanism

In 1979, a Franco-German initiative set up the European Monetary System (EMS) 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 Luxemburg) were then required to maintain their exchange rates within a 2.25% fluctuation band above or below each bilateral central rate. The ERM was an adjustable-peg system, and nine realignments would occur between 1979 and 1987. While the United Kingdom was not one of the original members, it would eventually join in 1990 at a rate of DM2.95 to the pound and with a fluctuation band of +/–6%.

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 government spending surged, forcing the Bundesbank to print more money. This led to high inflation and left the German central bank with little choice but to increase interest rates. However, the rate hike came with consequences as it placed upward pressure on the German mark. This forced other central banks to raise their interest rates as well as to maintain their pegged currency exchange rates (a direct application of Irving Fischer's interest parity theory). Realizing that the UK'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 the Success of UK Involvement in the 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 disequilibria, 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 (BoE) 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% rise in interest rates (from 10% to 12%) in an attempt to boost the pound's appeal. A few hours later, it promised to raise rates again to 15%, 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 BoE kept buying them until, finally, at 7:00 pm that same day, Chancellor Norman Lamont announced that Britain would leave the ERM and that rates would return to their initial level of 10%. The chaotic Black Wednesday marked the beginning of a steep depreciation in the pound's 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% against the deutschemark and 25% 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 others traders (the pound also weakened by a similar proportion to the dollar). Within a month, the quantum fund cashed in on approximately $2 billion by selling the now more expensive DMs 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.

Figure 2.2 GBPDEM after Soros

Figure 2.3 GBPUSD after Soros

Asian Financial Crisis (1997–1998)

Falling like a set of dominos on July 2, 1997, the relatively nascent Asian tiger economies provide the perfect example of the interdependence in 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, and immature capital markets. Compiled, these 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 Korea. Thailand, home of the baht, experienced a 6.5% growth rate in 1996, falling from 13% in 1988. Lending additional support for a stronger economy was the enactment of a fixed currency peg to the 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 largest economy. Ultimately, the region's national currencies appreciated, as underlying fundamentals were justified and increased speculative positions of further climbs in price mounted.

Ballooning Current Account Deficits and Nonperforming Loans

However, in early 1997, a shift in sentiment began 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 ballooned in 1996 to $14.7 billion and had been climbing since 1992. Although comparatively smaller than the U.S. deficit, the gap represented 8% of the country's gross domestic product. Shrouded lending practices also contributed heavily to these breakdowns, as close personal relationships with high-ranking banking officials were well rewarded and surprisingly common throughout the region. In particular this affected many of South Korea's highly leveraged conglomerates as total nonperforming loan values skyrocketed to 7.5 percent of gross domestic product. Additional evidence of these practices could be observed in financial institutions throughout Japan. First announcing questionable and nonperforming loans of $136 billion 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 their own asset bubble collapsed, asset prices fell by $10 trillion, with the fall in real estate prices accounting for nearly 65% of the total decline—the losses were 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 issued rhetoric on 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, a once-prized possession, was devalued by as much as 48 percent, even slumping closer to a 100% fall at the turn of the new year. The most adversely affected was the Indonesian rupiah. Also relatively stable prior to the onset of a “crawling peg” with the Thai baht, the rupiah fell a whopping 228%, worsening previously to a high of 12,950 to the fixed U.S. dollar. These particularly volatile price actions are shown in Figure 2.4. Among the majors, the Japanese yen fell approximately 23% from its high to low against the U.S. dollar between 1997 and 1998, and after having retraced a significant portion of its losses, ended the 8-month debacle down 15%, as shown in Figure 2.5.

Figure 2.4 Asian Crisis Price Action

Figure 2.5 USDJPY Asian Crisis Price Action

Lasting for less than a year, the financial crisis of 1997 revealed the interconnectivity of economies and their effects in the global currency markets. Additionally, it showed the inability of central banks to successfully intervene in currency valuations with the absence of secure economic fundamentals and overwhelming market forces. Today, with the assistance of IMF reparation packages and the implementation of stricter requirements, Asia's four little dragons are healthy once again. With inflationary benchmarks and a revived exporting market, Southeast Asia is building back its once prominent stature among the world's industrialized economic regions. With the experience of evaporating currency reserves under their belt, the Asian tigers now take active initiatives to ensure that there is large pot of reserves on hand in case speculators attempt to attack their currencies once again.

Introduction of the Euro (1999)

The introduction of the euro was a monumental achievement, marking the largest monetary changeover ever. The euro was officially launched as an electronic trading currency on January 1, 1999. Euro notes and coins were put into circulation in 2002. The 11 initial member states were: Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal, and Finland. As of 2015, there are 17 countries in the Eurozone. Each country fixed its currency to a specific conversion rate against the euro, and a common monetary policy governed by the European Central Bank (ECB) was adopted. To many economists, the system would ideally include all of the original 15 EU nations, but the United Kingdom, Sweden, and Denmark decided to keep their own currencies. In deciding whether to adopt the euro, EU members have many important factors to consider.

The 1993 Maastricht Treaty sets out five main convergence criteria for member states to participate in the European Monetary Union (EMU):

Maastricht Treaty: Convergence Criteria

• The country's government budget deficit could not be greater than 3% of GDP.
• The country's government debt could not be larger than 60% of GDP.
• The country's exchange rate had to be maintained within ERM bands without any realignment for two years prior to joining.
• The country's inflation rate could not be higher than 1.5% above the average inflation rate of the three EU countries with the lowest inflation rates.
• The country's long-term interest rate on government bonds could not be higher than 2% above the average of the comparable rates in the three countries with the lowest inflation.

Although the ease of traveling is one of the most attractive reasons to join the euro, being part of the monetary union provides other benefits:

• It eliminates exchange rate fluctuations, providing a more stable environment to trade within the euro area.
• The purging of all exchange rate risk within the zone allows businesses to plan investment decisions with greater certainty.
• Transaction costs also diminish, mainly those relating to foreign exchange operations, hedging operations, cross-border payments, and the management of several currency accounts.
• Prices become more transparent as consumers and businesses can compare prices across countries more easily, which, in turn, increases competition.
• A huge single currency market becomes more attractive for foreign investors.
• The economy's magnitude and stability allow the ECB to control inflation with lower interest rates, thanks to increased credibility.

Yet the euro is not without its limitations. Leaving aside political sovereignty issues, the main problem is that, by adopting the euro, a nation essentially forfeits any independent monetary policy. Since each country's economy is not perfectly correlated to the EMU's economy, a nation might find the ECB hiking interest rates during a domestic recession. This can be particularly true for many of the smaller nations. As a result, countries try to rely more heavily on fiscal policy, but the efficiency of fiscal policy is limited when it is not effectively combined with monetary policy. This inefficiency is further exacerbated by the 3% of GDP limit on budget deficits, as stipulated by the Stability and Growth Pact.

Some concerns also subsist regarding the ECB's effectiveness as a central bank. The central bank strives for a 2% inflation target, but in the past 15 years, it strayed away from this level often. Also, from 1999 to late 2002, a lack of confidence in the union's currency (and in the union itself) led to a 24% depreciation, from approximately $1.15 to the euro in January 1999 to $0.88 in May 2000, forcing the ECB to intervene in foreign exchange markets in the last few months of 2000. Figure 2.6 shows a daily chart of the euro since it was launched in 1999.

Figure 2.6 EURUSD Price Since Launch

Source: eSignal

Since 2000, things have greatly changed, with the euro trading at a premium to the dollar, but quantitative easing in 2014 put the currency back in a downtrend versus the dollar. Some analysts claim that the euro will one day replace the dollar as the world's dominant international currency, and while we believe it will have a greater share in reserve portfolios, we doubt that this will be likely.