Treasury and Federal Reserve foreign exchange operations.

Treasury and Federal Reserve Foreign Exchange Operations

This quarterly report, covering the period November 1989 through January 1990, provides information on Treasury and System foreign exchange operations. It was presented by Sam Y. Cross, Manager of Foreign Operations of the System Open Market Account and Executive Vice President in charge of the Foreign Group of the Federal Reserve Bank of New York. George G. Bentley was primarily responsible for preparation of the report.(1) Movements of the dollar against individual currencies diverged widely between November 1989 and January 1990--a period when the rapid opening up of Eastern Europe benefited the German mark and a number of factors continued to weigh against the Japanese yen. The dollar experienced occasional bouts of upward pressure against the yen, and on several of these occasions the U.S. monetary authorities intervened to resist the dollar's rise against that currency, selling a total of $750 million for yen. On balance, the dollar declined against the mark and other European currencies, moving down 8 1/2 percent, 7 1/4 percent, and 6 percent respectively against the mark, Swiss franc, and British pound. The dollar rose, however, about 1 percent against both the yen and the Canadian dollar. On a trade-weighted basis, as measured by the staff of the Board of Governors of the Federal Reserve System, the dollar declined 5 3/4 percent.

NOVEMBER THROUGH MID-DECEMBER

The movement in dollar exchange rates against the European currencies was most marked during the first half of the reporting period. Positive sentiment toward the mark built rapidly after the opening on November 9 of the borders between East and West Germany. Market participants anticipated that an influx of East German immigrants would benefit the German economy by providing a new supply of skilled labor. At the same time, the new immigrants were expected to stimulate domestic demand and thereby spur higher mark interest rates as the Bundesbank sought to contain any potential inflationary pressures. More broadly, international investors focused on the prospects for greatly expanded market opportunities for German enterprises, and the German equity market surged in response to actual and anticipated capital inflows.

Against this background, the mark strengthened against all major currencies, and talk began to circulate, especially around the December 8-9 European Community summit, that exchange market pressures would lead to a revaluation of the mark within the European Monetary System (EMS). Germany has had large sustained trade surpluses against most of its European trading partners. Moreover, the German authorities were presumed to welcome any developments that would foster adjustment of the trade surplus or help dampen inflationary impulses to the economy. Market participants believed that a realignment within the EMS would be viewed by Bundesbank officials as consistent with both of these objectives. Accordingly, speculative flows into marks increased, and reports circulated in the market that the Bundesbank's partner central banks were intervening to sell both dollars and marks to support their own currencies.

In the process, the dollar declined steadily against the mark. From DM1.8415 at the beginning of November, the dollar declined by mid-December to around DM1.7300, a drop of 6 percent.

Against the yen, the dollar showed less of a trend, although it experienced upward pressure from time to time when there were reports of strong Japanese investor demand for portfolio and direct investments in the United States. Market participants were particularly impressed that Japanese interest in investing in dollar-denominated assets appeared to remain strong, even though market commentary about the outlook for U.S. and Japanese monetary policy implied that the interest rate differentials favoring the dollar would continue to narrow. Once in November and again in early December, the U.S. monetary authorities, in keeping with understandings in the Group of Seven on exchange rate cooperation, intervened to sell a total of $150 million against yen. These operations were coordinated with the Bank of Japan. By mid-December, the dollar was trading around [Yen] 144.00, a level 3/4 percent higher than at the start of the reporting period.

MID-DECEMBER THROUGH JANUARY

In mid-December, one focus of market attention was the extent to which monetary policies in the United States and Japan might move in opposite directions. Economic statistics released through mid-December suggested that the U.S. economy was still sluggish and price pressures subdued, keeping alive expectations that U.S. interest rates would continue to move lower. The market's hope that the Federal Reserve had intended to signal a new easing of monetary policy in November had proved unfounded. But market participants were still confident that the Federal Reserve would continue to respond, as it had in preceding months, to evidence of a decelerating economy by allowing short-term interest rates to ease a bit further. Indeed, the Federal Reserve moved on December 20 to supply liquidity under circumstances that led market participants to believe that another such move had occurred, and they anticipated that further moves would be forthcoming early in the new year.

In Japan, market participants had noted that short-term market interest rates had drifted progressively higher for several months, and that this trend had continued even after the Bank of Japan raised its discount rate in a surprise move in October. Trying to anticipate the authorities' next action, dealers were sensitive to the possibility that the Bank of Japan might again raise its discount rate to follow up on the move in market rates. When such an action did not occur by mid-December, market participants began to suspect that these expectations might not be fullfilled. They began to doubt that the authorities would move on interest rates at a time of impending changes in Bank of Japan leadership and so soon before parliamentary elections in early 1990. Market participants were surprised, therefore, when Japanese newspapers reported on December 18 that the Bank of Japan would soon raise its discount rate, a move that indeed took place on December 25. When worldwide trading resumed after the Christmas holidays, the dollar declined to its period low against the yen of [Yen] 141.70 on December 27 and a twenty-month low against the mark of DM1.6752 on December 28--1 percent and 9 percent lower respectively than at the start of November.

In early January, the market's assessment of the outlook for dollar interest rates began to change. Accumulating signs that the U.S. economy had stopped decelerating began to raise doubts about both the timing and the extent of any further easing of U.S. monetary policy. Data released around the turn of the year suggested that growth might not be as fragile as had previously been thought and that the slowdown in some manufacturing sectors in late 1989 had not spilled over into other sectors of the economy. Unseasonably cold weather led to a sharp runup in oil prices and heightened concerns about renewed price pressures in the food and energy sectors. The January 12 report of an unexpectedly large jump in U.S. producer prices was then interpreted as justifying concerns that little scope remained for further immediate declines in dollar interest rates. Later in January, the dollar received additional support as market participants focused on interpretive press reports indicating the Federal Reserve's concerns with inflation and its more optimistic assessment of economic growth prospects in 1990. When trading resumed after the new year, this reassessment helped to move the dollar up from its lows of late December and provided continuing support to the dollar throughout the rest of January.

Against the yen, the dollar also benefited early in January from the potential uncertainties the surrounding the upcoming parliamentary elections in Japan. Around the start of the new year, rumors of scandals involving members of the ruling Liberal Democratic Party once again unsettled the exchange markets, and the dollar reached its three-month high against the yen at [Yen] 146.80 on January 3. With upward pressure on the dollar-yen exchange rate persisting throughout the first half of the month, the U.S. monetary authorities again intervened, on three days, to sell $600 million against yen. These operations, which were coordinated with the Bank of Japan, brought the total of U.S. intervention for the November-January period to $750 million, shared equally by the Federal Reserve and the U.S. Treasury. The dollar closed the period at [Yen] 144.45, roughly 1 percent higher than at the start of November.

The dollar recovered little against the mark in early January. At this time, talk revived of a revaluation of the German mark within the EMS. In fact, an adjustment of the EMS was announced on January 5 to accommodate a request from the Italian government to bring the Italian lira within the narrow band of the exchange rate mechanism of the EMS. When this relatively modest adjustment occurred smoothly and without a generalized realignment, expectations of further near-term adjustments of exchange rates diminished. The dollar's low for the period was DM1.6630 on January 8.

For the remainder of January, movements in the dollar-mark exchange rate were dominated by events in Eastern Europe. Although indications of heavy investor demand for the mark continued to support that currency, reports in mid-January began to reveal the fragility of the government structure in East Germany and elsewhere in Eastern Europe. Doubts also were voiced about political stability in the Soviet Union, especially in light of mounting separatist movements in several Soviet republics. These fears somewhat dampened the near-term enthusiasm for the mark, which traded with little clear direction for the rest of the month. The dollar closed the period against the mark at DM1.6850.

Uncertainty about the implications of the widespread political and economic changes taking place was reflected in increased volatility in the world equity and bond markets during January. This volatility, together with convergence of long-term interest rates in the United States, Germany, and Japan, and the attraction of new investment opportunities in Europe, revived concerns about the continued smooth financing of the U.S. current account deficit. In this context, dollar rates from day to day were sometimes influenced by sharp movements in other financial markets. But for the month as a whole, these developments appeared to have little lasting effect on dollar exchange rates.

Against the Canadian dollar, the dollar trended lower throughout the three-month period until mid-January. The dollar reversed its course at that time, when a move by the Bank of Canada to ease interest rates precipitated a sell-off of the Canadian currency.

In other operations, the U.S. Treasury through the Exchange Stabilization Fund (ESF), together with the Bank for International Settlements (BIS), acting for certain participating central banks, agreed to provide short-term support of $500 million to the National Bank of Poland for its economic stabilization and reform efforts, effective December 27. The ESF's share in the facility was $200 million. On December 28, Poland drew $86 million of the ESF's portion.

Also during the period, Bolivia on December 29 repaid in full its $75 million outstanding drawing of a $100 million facility established with the ESF. On the same day, Bolivia drew the full amount of a newly established facility of $75 million. The drawing was fully repaid upon maturity on January 12 (table 2).

On four separate occasions, Mexico repaid portions of its outstanding swap commitments under the $2,000 million facility established with the U.S. monetary authorities, the BIS (acting for certain participating central banks), and the Bank of Spain. The Federal Reserve and the ESF each received a total of $50 million (table 3).

As of the end of January, cumulative or valuation gains on outstanding foreign currency balances were $2,709.6 million for the Federal Reserve and $2,011.0 million for the ESF (table 4). (Valuation gains on holdings warehoused by the ESF with the Federal Reserve are excluded in the first figure and, correspondingly, included in the second figure.) These valuation gains represent the increase in dollar value of outstanding currency assets valued at end-of-period exchange rates, compared with the rates prevailing at the time the foreign currencies were acquired.

The Federal Reserve and the ESF regularly invest their foreign currency balances in a variety of instruments that yield market-related rates of return and have a high degree of quality and liquidity. A portion of the balances is invested in securities issued by foreign governments. As of the end of January, holdings of such securities by the Federal Reserve amounted to $7,180.4 million equivalent, and holdings by the ESF amounted to the equivalent of $7,477.6 million. [Table 1 to 4 Omitted]

(1)The charts for the report are available on request from Publications Services, Board of Governors of the Federal Reserve System, Washington, D.C. 20551.