by Jason Jenkins, Investment U Research
Thursday, September 6, 2012
George Soros made more than $1 billion in 1992 on the basic premise that something was not right. Specifically, he saw that Great Britain’s currency was about to fall apart.
Black Wednesday refers to the events of September 16, 1992, when the British government had no choice but to withdraw the pound from the European Exchange Rate Mechanism (ERM) when they couldn’t keep the pound above its agreed lower limit. Soros made his $1 billion profit by shorting the British currency.
How, Exactly, Did This Happen?
Two decades ago, England had pegged its currency to Europe’s ERM. “Pegging” is a means of stabilizing a nation’s currency by fixing its exchange rate to that of another currency. The concept for pegging to a single currency becomes more attractive if the peg is to the currency of a trading partner. Usually a pegged exchange rate will have some sort of beginning target exchange rate, and the actual exchange rate will be allowed to move in a specific range around that beginning rate.
The ERM was the predecessor to the euro. It was introduced in 1979 in an attempt to reduce currency inconsistency and achieve monetary stability in Europe.
The peg was set up to create a sense of economic harmony between the island and the continent. However, Soros realized that the peg was unsustainable. The economies of Britain and the European Union were just too different.
As the British government attempted to keep up this fixed rate, the process left Britain with high interest rates and inflation.
Soros saw that maintaining this standard was in fact fighting market forces. So he took up huge short positions against the pound. The government raised its interest rates to double digits to tempt potential investors. Britain was desperate to ease the selling by pumping up buying pressure.
Amazingly, it took a while for the British government to realize that if you raise rates, you pay out more. Britain would lose billions of pounds by artificially propping up the currency. It was left with no choice but to withdraw from the ERM. The pound cracked and Soros’ short bet netted him a cool billion.
I gave you the history lesson because many pundits and investors out there believe that a similar situation is coming to fruition in Denmark. Denmark has pegged the krone to the euro and is doing some peculiar practices to keep it in place.
Extreme Pressure on the Danish Krone
Earlier this summer, the former head of Denmark’s Central Bank voiced concerns that the Danish krone was coming under intense pressure from investors seeking a safe haven currency against the euro. Nils Bernstein, the then governor of the Danish Central Bank, stated that the pressure on the krone is the worst he’s seen over his seven-year tenure as governor.
People “in the know” are aware that holding your cash in the krone is a lot safer than having euros. There’s the obvious fact that Denmark is rated “AAA,” while the Eurozone has to deal with those pesky PIIGS in the South.
These savvy investors also know that the influx of funds flowing into Danish bonds is due to the government’s slim budget deficit and current account surplus. Also, many hedge funds are taking long positions in the currency in case the euro fails.
All of this money pouring into the krone has the Danish government fighting to keep up its very narrow pegged exchange rate with the euro.
Those Crazy Danes…
In order to keep the krone pegged to the euro, Denmark’s Central Bank has been following these two curious procedures:
1) The Central Bank has cut interest rates below zero. That’s right. Interest rates are negative in Denmark to deter investors from using its currency to park money.
2) The Central Bank is selling its own currency and buying up euros. Denmark’s foreign currency reserves have more than doubled over the last four years. They hit record highs the last two consecutive months.
Red flags are being raised because it’s not natural for a nation to have negative interest rates or chose to buy a bad currency with it’s own good one. And some are seeing this as a new possible billion-dollar trade. But they may be a little too ambitious…
What to Expect Going Forward
When you take a look at all factors – especially the large flows of money coming into Denmark from those in Europe and global currency speculators – I think, as well as these investors, that the Denmark Central Bank will not continue to defend its peg to the euro forever.
The more problems the EU will face in the future, the more money that will come Denmark’s way. And it may seem a little more attractive than its fellow European safe havens. Denmark’s currency has been seen by some in the Forex world as less risky than the Swiss franc. The reason is that the Danish government has a true established peg rather than a floor in regards to the euro. This means that there is some protection in the case of a EU recovery
According to Stuart Fiertz, President of the London hedge fund Cheyne Capital, “Just because a peg has been in place a long time doesn’t mean it cannot break. It just means that it’s cheaper… If the euro cracks, the pressure to cut the peg will be overwhelming.”
If it comes to the point where Denmark will have to give up its pegged exchange rate, experts expect the krone to appreciate around 20% to 25%. That will move it in line with the other European “safe havens currencies” – like the Swiss franc and Norwegian krone – outside of the Europe Union.
I hope this shed’s a little light on the situation for you Forex traders out there…
JasonDon’t Expect a Black Wednesday in Denmark,