Treasury and Federal Reserve Foreign Exchange Operations.

This report, presented by Peter R. Fisher, Executive Vice President, Federal Reserve Bank of New York, and Manager, System Open Market Account, describes the foreign exchange operations of the U.S. Department of the Treasury and the Federal Reserve System for the period from April 2000 through June 2000. Laura Sarlo was primarily responsible for preparing the report.

The dollar ended the second quarter little changed against the euro and 3.1 percent stronger against the yen. The dollar initially appreciated as much as 5.9 percent and 6.2 percent against the euro and yen, respectively, but slipped midquarter as expectations for the U.S. economy moderated. On a trade-weighted basis, the dollar ended the period modestly stronger, having risen 1.3 percent against the currencies of the major U.S. trading partners. The U.S. monetary authorities did not intervene in the foreign exchange markets during the quarter.

At the beginning of the quarter, weakness in technology shares led declines in U.S. equity markets as the Nasdaq tell 27.4 percent during the first two weeks of April. The equity markets' decline reportedly fostered some flows into U.S. Treasury securities, and two-year yields fell 24 basis points during the same period. However, economic data released in April were widely interpreted as reflecting a pattern of strong growth along with some inflationary pressure, as retail sales and producer and consumer price indexes for March had exceeded expectations. Market participants anticipated further rate increases, raising consensus expectations for a May 16 tightening to 25 and then to 50 basis points. After its May 16 meeting, the Federal Open Market Committee (FOMC) announced a 50-basis-point increase in the federal funds target rate, raising it to 6.50 percent. Immediately after the meeting, the dollar appreciated 1.1 percent against the euro but was little changed against most other major currencies. Later in the quarter, economic data were widely interpreted as suggesting signs of moderation in the U.S. economy, and they contributed to a gradual depreciation of the dollar from its earlier highs.

WEAKENING OF THE EURO AND YEN AGAINST THE DOLLAR DURING THE FIRST HALF OF THE QUARTER

During the first half of the quarter, the dollar appreciated against most major currencies as market participants reaffirmed expectations that U.S. economic growth would continue to outpace that of other major economies, including the euro area, and as U.S. asset markets continued to be perceived as generally attractive investment opportunities.

Data released during this time indicated that the U.S. economy grew 5.4 percent year-on-year during the first quarter, while euro-area fourth-quarter gross domestic product rose 3.1 percent; and a June 9 release indicated that first-quarter euro-area economic growth was 3.2 percent year-on-year. In addition, surveys reflected global investors' preference for maintaining lower levels of exposure to euro-area assets or to further reduce euro holdings. Traders also suggested that euro sales related to merger and acquisition activity may have increased demand for other currencies. Additionally, euro-area political developments, including the resignation of Italian Prime Minister Massimo D'Alema and further tension between Austria and its European Union partners, may have dampened sentiment toward the euro.

[Graph omitted]

After starting the period at $0.9555, the euro fell to $0.8845 intraday on May 4, the lowest level since its January 1999 launch. The euro then rebounded as markets responded to numerous comments by euro-area senior officials regarding the prospects for intervention. Implied volatility in one-month euro-dollar options rose to a high of 15.1 percent on May 5.

The yen weakened 1.9 percent against the dollar during the first two weeks of the quarter. After Foreign Prime Minister Keizo Obuchi became incapacitated on the first day of the period and the March Tankan report indicated an improvement in business sentiment and a smaller-than-expected decline in planned capital expenditures, Japanese monetary authorities reportedly sold yen against other currencies. The yen weakened intraday from [yen] 102.82 to [yen] 105.65 against the dollar. For the remainder of the second quarter, the yen weakened a further 1.2 percent against the dollar although it appeared little affected by the change in the cabinet and the June 25 legislative election. Declines in the Nikkei and net portfolio investment outflows during the quarter may have also contributed to the yen's depreciation.

MODEST DEPRECIATION OF THE DOLLAR DURING THE SECOND HALF OF THE QUARTER

Beginning in late May, many market participants perceived a moderating trend in U.S. economic growth, as reflected in several economic data releases. Among these data releases were the weaker-than-expected National Association of Purchasing Managers and Chicago Purchasing Managers Index surveys, the employment report and the consumer price index for May, and retail sales data. This shift in growth expectations prompted many to revise downward their forecasts for further monetary tightening. The implied yield on the July federal funds futures contract declined 19 basis points from mid-May to the end of the quarter. During this period, market participants reassessed the probability of an FOMC rate increase at the June 28 meeting and began to debate the degree of additional tightening expected before the year-end. The revision in policy expectations, as well as a series of strong first-quarter earnings reports, boosted U.S. equities, with the Nasdaq gaining 12.4 percent between May 15 and the end of the quarter.

[Graphs omitted]

Growing expectations for moderating U.S. economic growth also contributed to the appreciation of a broad range of currencies against the dollar. On a trade-weighted basis, the dollar declined 1.9 percent in June against the currencies of the major U.S. trading partners. After June 1, the Canadian dollar and British pound strengthened 0.7 percent and 1.5 percent, respectively, against the U.S. dollar as market participants revisited forecasts for interest rate differentials.

In late May, the euro began a reversal of its April depreciation. Demand for the euro appeared to grow as short-term investors reportedly established long euro positions and some longer-term investors began buying the euro on dips. This retracement was also supported by the release of stronger-than-expected euro-area economic data, including euro-area industrial production and national consumer price indexes for March. Increases in M3 solidified expectations that the European Central Bank (ECB) would tighten monetary policy, although the June 8 announcement of a 50-basis-point rate increase, to 4.25 percent, exceeded market expectations. Some market participants suggested that the expectation for potential narrowing of the interest rate differential between the United States and the euro area supported the euro against the dollar. During the quarter, the spread between two-year dollar and euro swap rates narrowed 55 basis points, to 190 basis points.

However, the euro did not appreciate after the June 8 ECB announcement and subsequent official comments, which were interpreted as a signal that the ECB would not undertake any additional rate increases until September. Late in the period, market participants reconsidered such expectations after the release of higher-than-expected national and euro-area producer and consumer price indexes for June, along with continued increases in oil prices. Rising shorter-dated yields did not appear to support the currency, which retreated from its quarter-high close of $0.9655 on June 16 to end the period at $0.9537.

Compared with the euro, the yen appreciated more modestly against the dollar during the second half of the quarter. Market discussion of a possible end to the near-zero interest rate policy, a background factor throughout the quarter, intensified after mid-May. Comments by Bank of Japan officials contributed to some participants' estimations that the Bank of Japan's Policy Board was increasingly likely to repeal the near-zero interest rate policy, perhaps as early as July. Yields on six-month Japanese Treasury bills rose sharply, increasing from 0.06 to 0.18 percent.

[Graphs omitted]

Although the yen appreciated on a short-term basis on days when the possible end of the near-zero interest rate policy was a market focus, the dollar-yen exchange rate largely remained above the [yen] 105 level during the period. Widespread market concern that yen appreciation beyond [yen] 105 per dollar might prompt official action in currency markets may have supported the dollar against the yen. Ongoing concern about the Japanese corporate sector, marked by several notable bankruptcies and an absence of a pickup in bank lending, may also have limited the Japanese currency's appreciation. The June 25 election success of the Liberal Democratic Party led by Prime Minister Yoshiro Mori appeared to have little effect on the currency.

ELECTION CONCERNS SWAY MEXICAN ASSETS

The dollar appreciated 5.8 percent against the Mexican peso as the peso weakened against a broad range of currencies before the July 2 presidential election. Yields on short-dated Mexican debt instruments rose as investors sought to offset the additional perceived event risk and as the Banco de Mexico tightened monetary conditions by increasing the shortage of reserves in the banking system. Longer-dated yields rose more modestly, remaining within recent ranges. The Mexican sub-index of the J.P. Morgan Emerging Market Bond Index Plus spread over U.S. Treasuries rose from 354 to 381 basis points, underperforming the broader index by 50 basis points.

[Graph omitted]

TREASURY AND FEDERAL RESERVE FOREIGN EXCHANGE OPERATIONS

The U.S. monetary authorities did not undertake any intervention operations during the quarter. At the end of the quarter, the current values of euro and Japanese yen reserve holdings totaled $15.5 billion for the Federal Reserve System and $15.5 billion for the Treasury's Exchange Stabilization Fund. The U.S. monetary authorities invest all their foreign currency balances in various instruments that yield market-related rates of return and have a high degree of liquidity and credit quality. To the extent practicable, these investments are split evenly between the Federal Reserve System and the Exchange Stabilization Fund.

A significant portion of the balances is invested in German and Japanese government securities held directly or under repurchase agreement. Government securities held under repurchase agreement are arranged either through transactions executed directly in the market or through agreements with official institutions. Foreign currency reserves are also invested in deposits at the Bank for International Settlements and in facilities at other official institutions. As of June 30, direct holdings of foreign government securities totaled $8.2 billion, split evenly between the two authorities. Foreign government securities held under repurchase agreement totaled $13.3 billion at the end of the quarter and were also split evenly between the two authorities.

1. Foreign currency holdings of U.S. monetary authorities based on
current exchange rates. 2000:Q2

Millions of dollars

                                    Quarterly changes in balances,
                                              by source

                                 Balance
             Item               Mar. 31,
                                  2000
                                                Net
                                              purchases    Effect of
                                            and sales(1)    sales(2)

  FEDERAL RESERVE SYSTEM
   OPEN MARKET ACCOUNT
         (SOMA)

Euro                              6,597.4        0.0         0.0
Japanese yen                      9,171.4        0.0         0.0
  Total                          15,768.7        0.0         0.0

Interest receivables (net)(5)        34.3        ...         ...
Other cash flow from
  investments(4)                   ...           ...         ...

Total                            15,803.0        0           0

   U.S. TREASURY EXCHANGE
  STABILIZATION FUND (ESF)

Euro                              6,594.5        0.0         0.0
Japanese yen                      9,171.4        0.0         0.0
  Total                          15,765.9        0.0         0.0

Interest receivables(5)              59.8        ...         ...
Other cash flow from
  investments(4)                  ...            ...         ...

Total                            15,825.7        0           0

                                Quarterly changes in balances,
                                          by source

             Item

                                                Currency
                                Investment     valuation
                                  income     adjustments(3)

 FEDERAL RESERVE SYSTEM
  OPEN MARKET ACCOUNT
        (SOMA)

Euro                                58.6            -18.5
Japanese yen                         5.8           -299.3
  Total                             64.4           -317.7

Interest receivables (net)(5)       ...             ...
Other cash flow from
  investments(4)                    ...             ...

Total                               64.4           -317.7

   U.S. TREASURY EXCHANGE
  STABILIZATION FUND (ESF)

Euro                                58.6            -18.5
Japanese yen                         5.8           -299.4
  Total                             64.4           -317.8

Interest receivables(5)             ...             ...
Other cash flow from
  investments(4)                    ...             ...

Total                              64.4           -317.8

                                 Quarterly
                                changes in
                                 balances,
                                by source

             Item

                                  Interest     Balance
                                  accrual      June 30,
                                and other(4)     2000

 FEDERAL RESERVE SYSTEM
  OPEN MARKET ACCOUNT
        (SOMA)

Euro                                ...         6,637.5
Japanese yen                        ...         8,877.9
  Total                             ...        15,515.4

Interest receivables (net)(5)       0.2            34.5
Other cash flow from
  investments(4)                    4.6             4.6

Total                               4.8        15,554.5

   U.S. TREASURY EXCHANGE
  STABILIZATION FUND (ESF)

Euro                                ...         6,634.7
Japanese yen                        ...         8,877.8
  Total                             ...        15,512.5

Interest receivables(5)            -3.4            56.4
Other cash flow from
  investments(4)                    4.7             4.7

Total                               1.3        15,573.6

NOTE. Figures may not sum to totals because of rounding.

(1.) Purchases and sales for the purpose of this table include
foreign currency sales and purchases related to official activity,
swap drawings and repayments, and warehousing.

(2.) This figure is calculated using marked-to-market exchange
rates; it represents the difference between the sale exchange rate
and the most recent revaluation exchange rate. Realized profits and
losses on sales of foreign currencies, computed as the difference
between the historical cost-of-acquisition exchange rate and
the sale exchange rate, are reflected in table 2.

(3.) Foreign currency balances are marked to market monthly at
month-end exchange rates.

(4.) Values are cash flow differences from payments and collection
of funds between quarters.

(5.) Interest receivables for the ESF are revalued at month-end
exchange rates. Interest receivables for the Federal Reserve
System are carried at average cost of acquisition and are
not marked to market until interest is paid.

... Not applicable.
2. Net profits or losses (-) on U.S. Treasury
and Federal Reserve foreign exchange operations,
based on historical cost-of-acquisition exchange rates,
2000:Q2

Millions of dollars

                                           Federal       U.S. Treasury
                                           Reserve         Exchange
           Period and item               System Open     Stabilization
                                        Market Account       Fund

Valuation profits and losses on
outstanding assets and liabilities,
Mar. 31, 2000
Euro                                         -851.1        -1,067.8
Japanese yen                               -2,126.9        -2,339.1

Total                                      -2,978.0        -3,406.9

Realized profits and losses
from foreign currency sales,
Mar. 31, 2000-June 30, 2000
Euro                                            0.0             0.0
Japanese yen                                    0.0             0.0

Total                                           0.0             0.0

Valuation profits and losses on
outstanding assets and liabilities,
June 30, 2000
Euro                                         -869.6        -1,086.3
Japanese yen                                1,823.3         2,044.4

Total                                         962.7           958.2
3. Reciprocal currency arrangements, June 30, 2000

Millions of dollars

                          Amount of    Outstanding,
    Institution           facility    June 30, 2000

                            Reciprocal currency
                                arrangements

Bank of Canada             2,000             0.0
Bank of Mexico             3,000             0.0

Total                      5,000             0.0

                      Federal Reserve and U.S. Treasury
                         Exchange Stabilization Fund
                           currency arrangements

Bank of Mexico             3,000             0.0

Total                      3,000             0.0