Treasury and Federal Reserve foreign exchange operations.

This quarterly report describes Treasury and System foreign exchange operations for the period from February through April 1994. It was presented by Peter R. Fisher, Senior Vice President and Manager for Operations for the Federal Reserve Bank of New York. Ladan Archin was primarily responsible for preparation of the report.(1)

During the February-April period, the dollar declined 4.6 percent against the German mark, 6.5 percent against the Japanese yen, and 3.6 percent on a trade-weighted basis.2 On the last business day of the period, April 29, the Federal Reserve Bank of New York's Foreign Exchange Desk entered the market to purchase $500 million against the German mark and $200 million against the yen for the U.S. monetary authorities. Contemporaneously, Treasury Secretary Bentsen issued a statement confirming the intervention. In other operations, the Desk liquidated the nonyen and nonmark reserves of the Federal Reserve System and the U.S. Treasury Department's Exchange Stabilization Fund (ESF). After the assassination of the leading Mexican presidential candidate, U.S. monetary authorities provided a $6 billion temporary swap facility to Mexico. This facility was superseded on April 26, when the monetary authorities of the United States, Canada, and Mexico announced the creation of the North American Financial Group and the establishment of a trilateral foreign exchange swap facility.

THE DOLLAR RISES BRIEFLY IN EARLY FEBRUARY

As the period opened, many market participants had positioned themselves for an extended dollar rally. This anticipated appreciation of the dollar rested in part on the expectation that interest rate differentials would start to move more rapidly in the dollar's favor. Dealers believed that as the U.S. economy strengthened, the Federal Reserve would eventually tighten monetary conditions in the United States, perhaps by the end of the first quarter. Dealers also expected that the Bundesbank would bring short-term German interest rates down quickly, allowing rates in other parts of Europe to fall as well. Against this backdrop, market participants entered the period holding substantial long-dollar positions against the mark and the yen and also holding large positions in European government bonds. On February 4, Chairman Greenspan announced the decision of the Federal Open Market Committee (FOMC) to increase pressure on bank reserves, a move that resulted in an increase in the federal funds rate from 3.0 percent to 3.25 percent. The dollar spiked higher in the days immediately after the tightening, reaching period highs of DMI.7675 and 109.65[yen] before starting to drift lower.

THE DOLLAR DECLINES FIRST AGAINST THE YEN AND THEN THE MARK

As the February 11 summit meeting between President Clinton and Japanese Prime Minister Hosokawa approached, market participants increasingly expected that the two leaders would announce some form of compromise resolution of trade issues under discussion between the two countries in bilateral "framework" talks. Correspondingly, expectations grew that the dollar would start to appreciate once the meeting was over, and market participants began to build up significant long-dollar positions. The dollar closed at 108.13 [yen] on Thursday, February 10. Reflecting this positive sentiment toward the dollar, the premium on the dollar put options over equally out-of-the-money dollar call options diminished a few days before the meeting. Thus, when President Clinton and Prime Minister Hosokawa announced late in the afternoon on Friday, February 11, that they had failed to reach an agreement and were suspending the framework talks, surprised market participants began to unwind their long-dollar positions. The dollar began to decline in late New York trading and continued to move lower through Asian, European, and early New York dealings on Monday, February 14. The dollar's price adjustment against the yen culminated at about midday, when the dollar dropped sharply to an intraday low of 101.10[yen]. The dollar recovered by the end of the day, however, and traded above 103[yen] for the balance of the month.

As the Bundesbank's council meeting on February 17 approached, market participants anticipated that the German central bank would act to lower interest rates for the first time since early December 1993. Although the Bundesbank did reduce its discount rate 50 basis points to 5.25 percent, it disappointed these expectations by leaving its key money market rate, the securities repurchase rate, unchanged. The dollar--mark exchange rate began to trade lower in subsequent days, but sharp sell-offs in U.S. and European bond markets generally dominated market attention during late February.

In early March, the dollar traded above the 105[yen] level, gaining support from signs that Japan was considering private and public initiatives to address its trade surplus. Market participants also appeared to take comfort in the fact that the Clinton Administration's decision to revive "Super 301" trade sanction powers would not result--at least in the short term--in new trade sanctions. However, in mid-March attention increasingly focused on reports of the substantial foreign flows of funds into Japanese equity and bond markets leading to further strength in the yen.

Against the mark, a slower-than-expected narrowing of short-term interest rate differentials weighed on the dollar during much of March. A surge in German M3 money supply growth, coupled with growing frustration over the Bundesbank's cautious step-by-step reduction of its securities repurchase rate, spurred market participants to reassess their expectation of sharply lower German interest rates. These developments also encouraged the view that further rate reductions by the Bundesbank would be calibrated to the Federal Reserve's rate increases to minimize the impact on the dollar-mark exchange rate. In this environment, the second increase of 25 basis points in the federal funds rate resulting from the FOMC's decision, announced after its March 22 meeting, had little impact on the dollar.

DOLLAR MOVES UP AND THEN DOWN IN APRIL

In early April, the dollar moved higher against the mark and the yen on a much higher-than-expected increase in March U.S. nonfarm payrolls and on a brief recovery in U.S. securities prices. The dollar soon came under pressure against the yen, however, when the resignation of Prime Minister Hosokawa led to a widespread perception in the foreign exchange market that the bilateral trade talks would encounter further delays. Political uncertainty in Japan lingered, and dealers came to doubt whether Japan would be able to meet its commitment to have a new package of market-opening measures in place before the Group of Seven (G-7) summit in July. The political uncertainty in Japan also created a concern among dealers that the Japanese government would be unable to pass measures to stimulate domestic demand and that the yen would consequently appreciate over the longer term as well.

During April, a change in market perception strengthened the mark against both the dollar and the yen. With the Bundesbank easing cautiously since mid-February, the expected trend in short-term German interest rates, as implied by several series of Euromark futures contracts, backed up sharply over the latter part of the period. The surprise announcement by the Bundesbank on April 14 that it was cutting its discount and Lombard rates 25 basis points, to 5.0 percent and 6.5 percent respectively, appeared to signal to market participants that further significant near-term easing was unlikely. This can be seen in the flattening of near-term Euromark contracts around the 5 percent level. This was followed by the third 25 basis-point increase in the federal funds rate on April 18. With market participants perceiving little prospect for a further narrowing in the interest differential in the short run, the mark strengthened against both the dollar and the yen, as the short end of the German yield curve looked increasingly attractive.

The mark continued to rise against the dollar through the end of April, even though expected interest rate differentials, as implied by futures contracts on Eurodollar and Euromark deposits, were now moving more clearly in the dollar's favor. Sentiment toward the dollar became increasingly negative as dealers expressed growing anxiety that the dollar-yen exchange rate might break swiftly below its historical lows. This risk was reflected in options markets, where dollar put options traded at a substantial premium over equally out-of-the-money dollar call options. With market participants focused on the risk that the dollar might decline against the yen and with the mark having found solid support against the yen at the 60[yen] per mark level, the prospect for the dollar appreciating against the mark appeared remote.

After the G-7 meetings the weekend of April 23-24, market participants were somewhat disappointed over the lack of official guidance on exchange rates, and the dollar began to move down against both the mark and the yen. At this time, a perception was growing that dollar weakness had begun to affect the U.S. bond market adversely, and market participants expressed concern that a lower dollar would spark inflationary pressures and thereby diminish the value of dollar-denominated assets. Dealers increasingly focused on the parallel movements in U.S. bond prices and the value of the dollar. On Thursday, April 28, the U.S. bond market recorded sharp losses, and the dollar approached its postwar low of 100.40[yen] in thin and nervous trading.

U.S. MONETARY AUTHORITIES ENTER THE MARKET TO BUY DOLLARS AGAINST THE MARK AND THE YEN

On Friday, April 29, in early New York trading, the dollar started to drop abruptly against the mark, falling nearly two pfennigs in less than an hour before bottoming out at a six-month low of DM1.6440. At the time, the dollar was trading just below 102[yen]. Trading became increasingly volatile, with market participants reporting that dealers were not answering phones and that customers were having trouble finding out whether their orders had been filled. Shortly before 10:30 a.m., the Federal Reserve Bank of New York's Foreign Exchange Desk entered the market, purchasing dollars against the mark for the U.S. monetary authorities. Soon thereafter, Treasury Secretary Lloyd Bentsen issued the following statement confirming the intervention: "U.S. monetary authorities intervened today in foreign exchange markets to counter disorderly conditions. This is in line with our previously articulated policy which recognizes that excessive volatility is counterproductive to growth. We stand ready to continue to cooperate in foreign exchange markets."

Shortly before 11:30 a.m., the Desk again entered the market, purchasing dollars against both the mark and the yen. In total, U.S. monetary authorities purchased $500 million against the mark and $200 million against the yen; these amounts were equally divided between the Federal Reserve and the ESF.

After the intervention, the dollar began to gain ground in orderly trading, reaching an intraday high of 1.6635 against the mark, and 102.50 against the yen. The dollar drifted lower in the afternoon, however, and closed the period at DM1.6535 and 101.55[yen].

NORTH AMERICAN SWAP LINES

After the March 23 assassination of Luis Donaldo Colosio, the presidential candidate of Mexico's Institutional Revolutionary Party (PRI), U.S. monetary authorities established a $6.0 billion temporary bilateral swap facility for the Bank of Mexico at the request of the Mexican authorities. The facility included reciprocal swap arrangements already in place. The assassination of Colosio had prompted the closing of Mexican markets on March 24 and gave rise to concerns that the reopening of the markets on March 25 would be accompanied by market disorders that could spill over into the U.S. financial markets. No drawings were made on this facility.

On April 26, the monetary authorities of the United States, Canada, and Mexico announced the creation of the North American Financial Group to provide a forum for more regular consultation on economic and financial developments and policies in these countries. These arrangements were unrelated to developments in Mexico; they had been planned several months earlier in recognition of the three nations' increasingly interdependent economic relationships. In connection with the North American Financial Group, the monetary authorities of the three countries announced the establishment of the trilateral foreign exchange swap facility to expand the pool of potential resources available to the monetary authorities of each country to maintain orderly exchange markets. The United States and Mexico put in place swap agreements for up to $6.0 billion, with the Treasury and the Federal Reserve each participating up to $3.0 billion. In addition, the Bank of Canada and the Bank of Mexico expanded their existing swap agreement to C$1.0 billion. Finally, the Federal Reserve and the Bank of Canada reaffirmed their existing swap agreement in the amount of $2.0 billion. Each party has reciprocal privileges to draw on the other's currency in amounts equivalent to the amounts indicated.

The Mexican peso, which opened the period at 3.1060, traded to a low of 3.3694 per dollar after the assassination but strengthened toward the end of the period to close at 3.2700 pesos per dollar.

OTHER OPERATIONS

During the period, the Federal Reserve Bank of New York sold in the market all nonmark and nonyen foreign exchange reserve holdings of the Federal Reserve and the Exchange Stabilization Fund (ESF) of the U.S. Treasury. The Federal Reserve liquidated the equivalent of $703.8 million, while the ESF liquidated the equivalent of $64.4 million. Swiss francs represented $629.0 million of the amount liquidated by the Federal Reserve and $37.3 million of the amount liquidated by the Treasury. Swiss franc sales took place on the following days: February 15, February 22, March 1, March 8, April 5, April 12, and April 26.

The remaining sales for the account of the Federal Reserve were as follows: $1.0 million of Belgian francs on February 25; $38.0 million of Dutch guilders on March 29; $0.3 million of Canadian dollars on March 29; $26.9 million of British pounds on April 12; and $8.7 million of French francs on April 12. The remaining sales for the account of the Treasury was a liquidation of $27.1 million of British pounds on April 26. It was decided to eliminate these currency holdings in light of the practice of the U.S. monetary authorities in recent years to conduct intervention operations exclusively in German marks and Japanese yen. The sales were conducted in accordance with a preestablished schedule, reflecting the maturity of investments in the individual currencies.

At the end of the period, the current value of the foreign exchange reserve holdings of the Federal Reserve and the U.S. Treasury was $23.0 billion and $21.0 billion respectively. These holdings are invested in a variety of instruments that yield market-related rates of return and have a high degree of liquidity and credit quality. The Federal Reserve and the U.S. Treasury held, either directly or under repurchase agreements, $11.7 billion and $11.3 billion respectively in foreign government securities. 1. Foreign exchange holdings of U.S. monetary

authorities at period end

Millions of dollars

                           Federal        U.S. Treasury
                           Reserve        Exchange
      Item                                Stabilization Fund
German marks               13,615.8          8,413.7
Japanese yen                9,375.3         12,600.3
Total                      22,991.1         21,014.0

2. Net profits or losses (-) on U.S. Treasury

and Federal Reserve foreign exchange operations,

based on historical cost-of-acquisition exchange rates

Millions of dollars

                                       Federal     Exchange
                                       Reserve   Stabilization
                                                      Fund
Period and item
Valuation profits and losses on
  outstanding assets and Liabilities
  as of January 31, 1994               2,858.4          2,513.0
Realized profits and losses,
  January 31-April 29, 1994             81.7(1)           5.6(2)
Valuation profits and losses on
  outstanding assets and liabilities
  as of April 29, 1994                 4,163.4          3,804.9

3. Federal Reserve reciprocal currency arrangements

Millions of dollars

[TABULAR DATA OMITTED] (1.) The charts for the report are available from Publications Services, Board of Governors of the Federal Reserve System, Mail Stop 127, Washington, DC 20551. (2.) The dollar's movements on a trade-weighted basis are measured using an index developed by the staff at the Board of Governors of the Federal Reserve System.