Treasury and Federal Reserve foreign exchange operations.

This quarterly report describes Treasury and System foreign exchange operations for the period from April through June 1995. It was prepared by Peter R. Fisher, Executive Vice President, Federal Reserve Bank of New York, and Manager for Foreign Operations, System Open Market Account. Claudia Corra was primarily responsible for preparation of the report. (1)

During the second quarter of 1995, the dollar rose 0.6 percent against the German mark but it declined 2.1 percent against the Japanese yen, 1.9 percent against the Canadian dollar, and 0.3 percent on a trade-weighted basis.(2) The dollar, which had declined sharply during the first quarter of 1995 as expectations of higher U.S. interest rates subsided, remained under pressure through much of April. The dollar subsequently stabilized as diminished expectations of strong economic growth in Japan and Germany prompted market participants to consider the prospect for lower interest rates in these two countries and as market participants began to focus on a G-7 communique released in late April. By June, foreign exchange market activity had declined substantially as the dollar proceeded to settle into fairly narrow trading ranges despite increased volatility in U.S. interest rate markets. By the end of the second quarter, the dollar had risen 2.8. percent and 6.1 percent from its historic lows against the mark and the yen respectively.

The US. monetary authorities intervened in the foreign exchange markets on three occasions during the period - on April 3, April 5, and May 31 - purchasing a total of $3.6 billion against the German mark and the Japanese yen. On each occasion purchases by the U.S. monetary authorities were divided evenly between the Federal Reserve System and the US. Treasury Department's Exchange Stabilization Fund (ESF). In other operations, the Mexican authorities drew a total of $5 billion on their medium-term swap facility with the ESF. The Bank of Mexico also renewed its short-term swaps with the Federal Reserve and the ESF, each for $1 billion for an additional ninety days.

THE DOLLAR ENTERS THE QUARTER

UNDER PRESSURE

Toward the end of the first quarter the dollar continued to reach successive all-time lows against the yen and proceeded to close the quarter at 86.50 and DM 1.3735. Several factors weighing on the dollar at that time carried over into the second quarter. First, increasingly strong rhetoric from both sides surrounding the U.S.-Japan trade talks on automobiles and parts, as well as press reports that the United States was considering sanctions, appeared to herald a breakdown in the negotiations. Second, heavy dollar sales against the yen by Japanese corporations and financial institutions continued in early April despite the April I start of the new Japanese fiscal year. Finally, market rumors of dollar sales by Asian central banks added pressure on the U.S. currency.

US. MONETARY AUTHORITIES PURCHASE

DOLLARS AGAINST THE MARK AND THE YEN

On April 3, with the dollar trading at 86.50[yen], the Federal Reserve Bank of New York's Foreign Exchange Desk entered the market in Asian trading for the U.S. monetary authorities, purchasing $500 million against the yen from dealers in Tokyo, Singapore, Hong Kong, and Sydney. The dollar rallied briefly after the intervention but gave up all of its gains by the New York 6pen. At about 11:20 a.m. in New York, the Desk entered the market again, buying $750 million against the mark and $250 million against the yen. The dollar-yen operation was coordinated with the Bank of Japan. Treasury Secretary Robert E. Rubin confirmed the operation, stating, "This Administration believes a strong dollar is in America's interest, and we remain committed to strengthening the fundamentals that are ultimately important to maintaining a strong and stable currency." Overall, the U.S. monetary authorities purchased $1.5 billion during the course of the global trading day. However, the official purchases met sustained selling on any rally, and the dollar ended the day slightly lower, at DM 1.3722 and 86.10[yen].

On behalf of the U.S. monetary authorities, on April 5 the Desk again entered the market, at about 10:20 a.m., with the dollar trading at DM 1.3737 and 86.00[yen]. The Desk was joined in this operation by the Bundesbank and the Bank of Japan. Treasury Secretary Rubin confirmed the coordinated intervention, stating, "In effect, what you have is a shared commitment to a strong dollar, because it is in our interest and in the interests of the other economies of the world." During the day, the U.S. monetary authorities purchased $850 million against the mark and $250 million against the yen. The dollar initially rallied on the intervention, reaching intraday highs of DM 1.3860 and 86.63[yen], before drifting lower in thin aftemoon markets to close essentially unchanged at DM 1.3720 and 86.01[yen].

THE DOLLAR REACHES A NEW HISTORICAL

LOW AGAINST THE YEN

After these operations in early April, the dollar continued to dechne against the yen. Increasingly, market participants viewed the sustained appreciation of the yen as a symptom of underlying structural problems in the Japanese economy. As a result, they began to focus their attention on the need for new monetary, fiscal, and deregulatory measures from the Japanese authorities to stimulate domestic demand and spur import growth. To help stem the yen's rise, the Japanese authorities unveiled an emergency economic plan on April 14. That day the Bank of Japan also cut its official discount rate (ODR) 75 basis points, to I percent. Despite the cut in interest rates, the dollar-yen exchange rate received httle support from the package as many dealers viewed the fiscal and deregulatory measures as lacking in specifics. In addition, the absence of progress in the U.S.-Japan auto talks led U.S. officials to raise publicly the possibility of imposing trade sanctions against Japan, adding further downward pressure on the dollar. On Wednesday, April 19, the dollar reached a new low of 79.75[yen].

The dollar also reached a period low that day of DM 1.3472 against the mark - close to the historical low of DM 1.3438 reached on March 8, 1995. Other factors weighing on the dollar-mark exchange rate included heightened political concerns ahead of the first round of the French presidential election and regional elections in Italy, both scheduled for April 23, which led to renewed appreciation of the mark within Europe. Moreover, in the United States, expectations unwound for any further monetary tightening as a series of weaker-than-expected U.S. economic data releases - particularly declines in retail sales, industrial production, and housing starts-appeared to signal a clear slowdown in the pace of U.S. economic growth.

THE DOLLAR BEGINS TO STABILIZE

The dollar began to stabihze against both the mark and the yen in late April and early May. First, the overhang of long-dollar positions against the yen, evident at the start of the period, apparently began to dissipate. Second, anticipation of the April 25 meeting of G-7 finance ministers and central bank governors helped lift the dollar off its lows as dealers began to speculate about the possibility of a coordinated policy response to dollar weakness. Subsequent to the meeting, the G-7 finance ministers and central bank governors released the following statement:

The Ministers and Governors expressed concern about recent developments in exchange markets. They agreed that recent movements have gone beyond the levels justified by underlying economic conditions in the major countries. They also agreed that orderly reversal of those movements is desirable, would provide a better basis for a continued expansion of international trade and investment, and would contribute to our common objectives of sustained non-inflationary growth. They further agreed to strengthen their efforts in reducing internal and external imbalances and to continue to cooperate closely in exchange markets.

By the end of April the dollar reached DM 1.3855 and 84.15[yen].

In early May, international investors began to unwind their long German mark positions established during the first quarter, when exchange rate volatility had created a rush toward mark-denominated assets. First, investors began to increase their exposure to the higher yielding European markets, particularly after pre-election uncertainties in Italy and France receded, and these flows helped weaken the mark within Europe. Second, portfolio managers, many of whom were underweight U.S. assets, began to underperform their benchmarks when the U.S. bond market rally accelerated. As these investors, in turn, increased their exposure to the U.S. market, the dollar moved further off its lows.

Buoyed by these flows, the dollar remained steady despite further signs of weakness in the U.S. economy, particularly the April nonfarm payroll report, and associated speculation that the Federal Reserve might need to lower interest rates. Similarly, the dollar had little reaction to the May 10 announcement that, because of a breakdown in U.S.-Japan trade talks on automobiles and parts, the United States would initiate sanctions against Japan. The dollar's ability to trade through these ostensibly negative developments suggested to some market participants that, by early May, the dollar's recent problems had become fairly well discounted.

THE DOLLAR RALLIES SUDDENLY

On May 11 and 12, several factors came together to propel the dollar higher. Early on May 11, the U.S. House Budget Committee approved a series of deficit reduction measures, causing some shortcovering on increased optimism over the U.S. fiscal outlook. During the European trading session, holders of short-dollar positions were further unnerved by market reports of dollar buying by some large Asian accounts. These factors helped lift the dollar through the technical resistance level of DM 1.3920, bringing the dollar to DM 1.4120 by the time the New York market opened. Later that morning, Bundesbank President Hans Tietmeyer said that both Germany and its partner economies would suffer if the mark remained overvalued and added that, "We are not . . . interested in a sustained currency overvaluation." The dollar subsequently broke through the long-standing technical resistance level of DM 1.4225, causing the dollar to spike higher as dealers scrambled to cover substantial short-dollar positions. Over the two-day period, the dollar rose six pfennigs, to DM 1.4465, and three yen, to 86.65[yen]. Buoyed by the dollar's sharp rise, sentiment toward the U.S. currency turned quickly positive, a shift that encouraged some fresh dollar buying. On May 18 and 22, the dollar reached intraquarter highs of DM 1.4618 and 87.72[yen] respectively.

However, a lack of follow-through buying disappointed some market participants. The dollar was also adversely affected by weaker-than-expected US. durable goods data and existing home sales data, which prompted market participants to speculate on a possible interest rate ease by autumn. With market liquidity reduced because of holidays in Europe, the dollar fell sharply on May 25 and 26, reaching DM 1.3740 and 82.45[yen].

G-10 COUNTRIES INTERVENE TO SUPPORT

THE DOLLAR

On the morning of Wednesday, May 31, with the dollar trading at DM 1.3850 and 82.70[yen], the Desk entered the market in concert with the central banks of the other G-10 countries, purchasing dollars against marks and yen in an operation initiated by the U.S. monetary authorities. The U.S. monetary authorities' purchases totaled $500 milhon against the mark and $500 milhon against the yen.

The operation took the market by surprise, triggering a shortcovering rally. Treasury Secretary Rubin confirmed the intervention as consistent with objectives expressed in the G-7 communique of April 25. Market participants interpreted the operation as a signal of increased coordination by the major central banks and a reflection of their mutual desire for a stronger dollar. The dollar closed the day at DM 1.4135 and 84.40[yen].

THE DOLLAR TRADES IN NARROW RANGES

AGAINST THE MARK AND THE YEN DURING

MOST OF JUNE

During June, the dollar settled in narrow trading ranges of DM 1.3880 to DM 1.4200 and 84.00[yen] to 85.50[yen]. Dealers became increasingly reluctant to take risks, in part because of May's volatile dollar moves but also because of fears of further coordinated intervention ahead of the G-7 summit, held in Halifax, Canada, on June 15-17. While the G-7 Halifax communique offered no new initiatives on the dollar, it endorsed the April statement of the G-7 finance ministers and central bank governors, which called for an "orderly reversal" of the dollar's decline.

Increased uncertainty over the near-term outlook for interest rate differentials with Germany and Japan also kept the dollar pinned in narrow trading ranges. The surprisingly weak May nonfarm payroll number released on June 2 reinforced market perceptions of slower U.S. economic growth and increased market participants' expectations of an ease in U.S. monetary policy. At the same time, market participants also began to focus on the prospects for rate cuts in Germany and Japan.

In Germany, weak industrial production data for February and M3 data for the first quarter introduced the idea of a possible Bundesbank ease before the Bundesbank council's midsummer recess. In Japan, continued signs of stagnant demand and growing concerns over the health of Japan's banking system prompted fears that Japan would slip back into recession.

Throughout June, market participants increasingly took the view that the United States would impose trade sanctions on Japan on June 28, as announced in early May. Despite this possibility, the dollar-yen exchange rate traded with a steady tone, in part, because market participants were unable to reach a consensus on the ultimate impact of sanctions. Some viewed the likely imposition of sanctions as negative for the dollar, while others held the opposite view, expecting that sanctions would effect a faster reduction in the Japanese trade surplus. The dollar briefly rallied after the June 28 agreement between the United States and Japan on automobiles and parts but soon gave up its gains as dealers came to view the commitments involved as insufficient to materially reduce Japan's trade surplus. The dollar closed the quarter at DM 1.3812 and 84.65[yen].

MEXICAN FINANCIAL MARKETS FIND A

RANGE OF STABILITY

Over the period, Mexican financial markets recovered substantially as the economy began to show the effects of tough monetary and fiscal policies and as some foreign investors cautiously returned to the Mexican markets. The Mexican peso steadied for the first time since the December 1994 devaluation, appreciating approximately 7.5 percent against the dollar during the quarter. Mexico's Indice de Precios y Cotizaciones stock market index recovered as well, rising 19.8 percent in local currency terms. Nominal interest rates fell dramatically, reflecting diminished inflation expectations. Mexico's inflation rate peaked in April and then started to decline, prompting most market analysts to anticipate further declines later this year.

MEXICAN SWAP ACTIVITY

The Mexican authorities drew $3 billion on April 19 and $2 billion on May 19 on their medium-term facility with die ESF, bringing the total amount drawn by Mexico under the Medium-Term Exchange Stabilization agreement to $8 billion. In addition, on May 3, the Bank of Mexico renewed its short-term swaps with the ESF and the Federal Reserve System for an additional ninety days, each for $1 billion.

CANADIAN MONETARY POLICY EASES

Canadian financial markets performed positively over the period, as concerns over the federal budget deficit and fears of Quebec independence receded. The April 12 decision by Moody's to downgrade the federal government's foreign currency debt to Aa2 from Aa1, and its domestic debt to Aa1 from Aaa, was largely anticipated and had little market impact. The Canadian dollar, having opened the quarter at Can$1.3990, reached a period high of Can$1.3475 on May 15.

On May 8, the Bank of Canada began to ease monetary policy after a succession of weaker-than-expected Canadian economic data releases. Over the period, the call money target range declined a cumulative 75 basis points, to 7.00-7.50 percent. Initially pressured by the easier monetary policy stance, the Canadian dollar withstood the successive declines in interest rates and proceeded to consolidate in a range of Can$1.3720-can$1.3820.

TREASURY AND FEDERAL RESERVE

FOREIGN EXCHANGE RESERVES

The U.S. monetary authorities intervened three times during the period, buying a total of $1.5 billion against yen and $2.1 billion against marks. On all three occasions, intervention operations were divided evenly by the Federal Reserve System and the ESF.

At the end of the period, the current values of the foreign exchange reserve holdings of the Federal Reserve System and the ESF were $24 billion and $29.1 billion respectively. The U.S. monetary authorities regularly invest their foreign currency balances in a variety of instruments that yield market-related rates of return and have a high degree of liquidity and credit quality. A portion of the balances is invested in foreign-government-issued securities. As of June 30, the Federal Reserve System and the ESF held, either directly or under repurchase agreement, $9.8 billion and $13.5 billion respectively in foreign-government-issued securities.

(1.) The charts for the report are available on request from Publications Services, Mail Stop 127, Board of Govemors of the Federal Reserve System, Washington, DC 20551. (2.) The dollar's movements on a trade-weighted basis in terms of other Group of Ten (G- 10) cuffencies are measured using an index developed by staff at the Board of Governors of the Federal Reserve System.

1. Foreign exchange holding of U.S. monetary authorities, based on current exchange rates

[TABULAR DATA OMITTED]

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

1. Purchases and sales include foreign currency sales and purchases related to official activity, swap drawings and repayments, and warehousing.

2. Calculated using marked-to-market exchange rates; represents the difference between the scale exchange rate and the most recent revaluation exchange rate. Realized profits and losses on sales of foreign currencies, computed as the difference between the historic cost-for-acquisition exchange rate and the sale exchange rate, are shown in table 2.

3. Foreign currency balances are marked to market monthly a month-end exchange rates.

4. See table 4 foor a breakdown of Mexican swap activities. Note that the investment income on Mexican swaps is sold back to the Bank of Mexico.

5. Valuation adjustments on peso balances do not affect profit and loss because the effect is offset by the unwinding of the forward contract at the repayment date. Note that the ESF doeos not mark-to-market its peso holdings, buut the Federal Reserve System does. However, Mexico is obligated to maintain in dollar terms the value of ESF peso holdings resulting from Mexican drawings under the Medium-Term Exchange Stabilization Agreement.

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

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

and Federal Reserve foreign exchange operations,

based on historical cost-of-acquisition exchange rates

[TABULAR DATA OMITTED]

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

1. As indicated in table 1, foreign currency sales totaled $2,100 million against German Deutsche marks and $1,500 million against Japanese yen.

2. Valuation profits or losses are not affected by peso holdings, which are canceled by forward contracts.

3. Currency arrangements
   Millions of dollars

     Institutions                   Amount of         Outstanding
                                    facility          June 30, 1995

     Federal Reserve
  Reciprocal Arrangements
Austrian National Bank                  250                 0
National Bank of Belgium              1,000                 0
Bank of Canada                        2,000                 0
National Bank Denmark                   250                 0
Bank of England                       3,000                 0
Bank of France                        2,000                 0
Deutsche Bundesbank                   6,000                 0
Bank of Italy                         3,000                 0
Bank of Japan                         5,000                 0
Bank of Mexico(1)
  Regular swaps                       3,000             1,000
  Temporary swaps                     3,000             1,000
Netherlands Bank                        500             1,000
Bank of Norway                          250             1,000
Bank of Sweden                          300             1,000
Swiss National Bank                   4,000             1,000

Bank for International Settlements
Dollars against Swiss francs            600             1,000
Dollars against other authorized
  European currencies                 1,250             1,000

Total                                35,400             1,000

     U.S. Treasury
     Exchange
  Stabilization Fund
Deutsche Bundesbank                   1,000                 0
Bank of Mexico(1)
  Regular swaps                       3,000             1,000
United Mexican States
  medium-term swaps(1)                                  8,000

Total(1)                                                9,000
  1. Facilities available to Mexico comprise regular and temporary short-term
swaps between the Bank of Mexico and both the Federal Reserve and
the ESF, as well as medium-term swaps and government guarantees between
the government of Mexico and the ESF. The total amount available from
both medium-term swaps and government guarantees is $20 billion, less any
outstanding drawings on the short-term facilities.

4. Drawings and repayments (-) by Mexican monetary

authorities

[TABULAR DATA OMITTED]

Note. Data are on a value-date basis.

1. Drawing of February 2 was renewed on May 3 for an additional ninety days.