Treasury and Federal Reserve foreign exchange operations.

This report describes Treasury and System foreign exchange operations for the period from July through September 1994. 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. Nicholas Pifer was primarily responsible for preparation of the report.(1)

During the July--September quarter, the dollar consolidated within increasingly narrow ranges. It rose 0.6 percent against the Japanese yen and 0.1 percent against the Mexican peso but declined 2.3 percent against the German mark, 2.9 percent against the Canadian dollar, and 1.9 percent on a trade-weighted basis.(2) Much of the period was characterized by thin summer markets and the predominance of interbank dealers and short-term speculative traders--conditions that occasionally resulted in abrupt but temporary movements in exchange rates. U.S. monetary authorities did not conduct any intervention operations during the quarter.

THE DOLLAR TRADES TO ITS LOWS OF THE PERIOD BUT SOON RETURNS TO ITS

OPENING LEVELS

At the end of the previous period, with the dollar trading at DM1.5869 and [yen]98.50, many market participants perceived a risk of a further decline in the dollar, given the prospect of stronger growth in Europe and concern about the continued trade imbalances of the United States and Japan. There was some market anticipation in advance of the Naples Summit that the G-7 might launch a coordinated "dollar support package." When no formal dollar support package was announced, the dollar resumed its decline. On Monday, July 11, the dollar dropped sharply as some market participants liquidated remaining long-dollar positions and others established sizable short-dollar positions. The dollar fell further the next day, briefly reaching a twenty-month low of DM1.5165 against the mark and a new postwar low of [yen]96.60 against the yen. With the dollar perceived as oversold on a technical basis, however, traders soon took profits on their short-dollar positions, and by the end of the week the dollar had recovered almost all of its post-summit losses.

The dollar rose further in mid-July, when senior U.S. officials articulated a clear preference for a stronger dollar and highlighted its advantages for the U.S. economy. Treasury Secretary Bentsen stated on July 14, "We're going to continue to be in accord with the Federal Reserve as far as their objectives to see that we have substantial growth with low inflation and work toward a stronger dollar." On July 20, Federal Reserve Chairman Alan Greenspan, in his semiannual Humphrey--Hawkins testimony before the Senate Banking Committee, said that he was troubled by the dollar's decline and noted, "any evidences of weakness in [the dollar] are neither good for the international financial system nor good for the American economy." The next day, Treasury Undersecretary Lawrence Summers, in his semiannual report to the Congress on international economic and exchange rate policy, stated the following:

The Administration believes that a strengthening of the dollar against the yen and the mark would have important economic benefits for the United States. It would restore the confidence in financial markets that is important to sustaining recovery. It would boost the attractiveness of U.S. assets and the incentive for longer-term investment in the economy, and help to keep inflation low. In addition we believe--and this view is shared by other G-7 countries--that a renewed decline of the dollar would be counterproductive to global recovery.

Market participants reacted positively to these remarks. Earlier worries that U.S. officials were unconcerned about the dollar began to dissipate, and by the end of July the dollar had moved back to DM1.5830 and [yen]99.85.

THE DOLLAR TRADES CAUTIOUSLY HIGHER AGAINST THE YEN

The dollar continued to rise gradually against the yen in late July and early August, reaching its period high of [yen]101.75 on August 8. At the time, the release of positive Japanese economic statistics, notably June industrial production data and new machinery orders, fostered a market perception that Japan's economy was improving and that increased imports would help reduce its trade surplus. Moreover, foreign investors turned into net sellers of Japanese bonds and equities in July, selling the equivalent of $5.8 billion, and this development may have helped to reduce the yen's strength. Against this backdrop, news that the United States and Japan had failed to reach an agreement on liberalizing Japan's government procurement sector before the July 31 deadline caused only a short-lived drop in the dollar. This muted reaction also reflected a realization that any possible U.S. trade sanctions would not be imposed before the end of a sixty-day "cooling off" period.

EXPECTATIONS OF HIGHER SHORT-TERM INTEREST RATES IN EUROPE EMERGE

In late July and early August, the dollar traded narrowly around the DM1.58 level despite its rise against the yen. In part, the dollar's limited movement reflected a steadily growing perception among market participants that the Bundesbank's process of easing short-term interest rates might be approaching its end. Moreover, increased market concern over large fiscal deficits in several European countries served to keep the mark firm against other European currencies and, secondarily, against the dollar.

On August 11, the central banks of Italy and Sweden surprised the markets with increases of 50 basis points in official lending rates and, in Sweden, a hike of 28 basis points in its key money market rate. For many market participants, these unexpected rate increases created a sudden anxiety that European interest rates, in general, had reached their trough and would now be rising. In the days after the news, bond yields in Germany and other European countries spiked higher, and the mark, buoyed by a flow of funds into mark-denominated money market instruments, rose abruptly against most European currencies. The mark also increased sharply against the dollar in the days after the rate hikes, moving from roughly DM1.59 to DM1.55. The dollar declined further after increases of 50 basis points in the U.S. federal funds rate and discount rate on August 16, as market participants apparently perceived a reduced likelihood of further U.S. rate hikes in the near term. The dollar fell to DM1.5265 on August 22 but then started to reverse.

THE DOLLAR SETTLES INTO A NARROW RANGE AGAINST THE MARK

In late August and early September, the dollar--mark exchange rate developed a trading pattern in which it would move uneventfully for much of each week but then react abruptly on Friday to a series of data releases on U.S. gross domestic product, nonfarm payrolls, producer prices, and industrial production and capacity utilization. The dollar's sudden swings on those Fridays appeared to track movements in U.S. bond prices, notably those of the thirty-year Treasury bond. This relationship appeared to reflect the view among some foreign exchange traders that the long bond offered a surrogate measure of foreign interest in U.S. securities and the view among other traders that the long bond provided a proxy for inflationary expectations in the U.S. economy.

1. Foreign exchange holdings of U.S. monetary authorities at period-end

Millions of dollars

       Item    Federal      U.S. Treasury
               Reserve        Exchange
                          Stabilization Fund
German marks   13,900.2         8,032.6
Japanese yen    9,163.9        12,415.2
Total          23,064.1        20,447.8

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

The dollar spent most of September between the DM1.5450 and DM1.5550 levels. In part, the dollar's tight range reflected an absence of large positions in the market and a clear reluctance on the part of market participants, many of whom had suffered trading losses during the first eight months of the year, to put capital at risk. The dollar's limited movement also appeared to reflect a mix of views on likely interest rate movements in the United States and Germany during the rest of the year. Some observers expected the Federal Reserve to raise U.S. rates aggressively to counter a perceived rise in inflationary pressures; others, anticipating a deceleration in U.S. growth, expected only a moderate rise in U.S. rates. Similarly, although most traders expected the Bundesbank to keep German rates on hold, some speculated that the Bundesbank would raise rates by year-end, although others continued to look for one more cut after the October 16 federal elections. During the latter part of September, as investors started to focus on uncertainty surrounding the German election, a reduction of long-mark positions against other European currencies provided modest support for the dollar against the mark. The dollar closed the period at DM1.5510.

THE DOLLAR ALSO SETTLES INTO A NARROW RANGE AGAINST THE YEN AS ATTENTION

SHIFTS TO U.S. TRADE TALKS WITH JAPAN

During the latter half of August, the dollar--yen exchange rate briefly dipped back below the [yen]98 level, moving lower in line with the dollar--mark exchange rate. Contributing to the decline was the August 18 release of U.S. trade data for June, showing a decrease in the overall trade deficit but an increase in the bilateral deficit with Japan, a development that refocused attention on U.S. trade relations with Japan.

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

                                               U.S. Treasury
         Period and item             Federal      Exchange
                                     Reserve     Stabilization
                                                    Fund
Valuation profits and losses on
  outstanding assets and liabilities
  as of June 30, 1994                4,458.2      4,253.8
Realized profits and losses,
  June 30, 1994--Sept. 30, 1994          0            0
Valuation profits and losses on
  outstanding assets and liabilities
  as of Sept. 30, 1994               4,973.4      4,356.7

NOTE. Data are on a value-date basis.

For the remainder of the quarter, the dollar traded between the [yen]98 and [yen]100 levels; in large part, movements within that range were driven by changing perceptions about the likely results of the framework trade talks between the United States and Japan and the chances of an agreement before the September 30 deadline. During the first half of September, the dollar firmed to the upper end of this range as comments by U.S. and Japanese officials suggested that the two sides were making progress toward an accord. Toward the end of the month, however, the dollar moved lower on news of a larger-than-expected U.S. trade deficit for July and on statements by U.S. officials suggesting that the United States would impose trade sanctions on Japan if the two sides failed to strike an agreement. As the period drew to a close, the dollar firmed again as a high-level team of Japanese officials traveled to the United States for a final round of negotiations, leading some market participants to expect a last-minute breakthrough. The dollar--yen exchange rate closed the quarter at [yen]99.10.

THE DOLLAR CLOSES UNCHANGED AGAINST THE MEXICAN PESO

Beginning in late July, market participants started to anticipate that Ernesto Zedillo, candidate of Mexico's Institutional Revolutionary Party (PRI), would win the August 21 presidential election. This view, combined with expectations of faster growth and lower interest rates in the year ahead, led to greater demand for Mexican stocks and peso-denominated government debt. Supported by such investor inflows, the Mexican peso rose modestly against the dollar, short-term Mexican interest rates fell, and the Mexican stock market increased about 20 percent in the month before the election.

With a Zedillo victory well discounted in the market by the time of the election, the peso gave up some of its gains on profit-taking once the results became clear. Subsequently, the market began to focus on the renegotiation of Mexico's annual wage and price agreemetn among business, labor, and government--known as the "Pacto"--which also governs the workings of Mexico's crawling band exchange rate regime. Foreign and domestic investors reacted favorably to the September 24 news of the Pacto's renegotiation, in which the peso's allowable rate of depreciation was left unchanged at 0.0004 pesos per day and Mexico's inflation target was lowered from 6 percent in 1994 to 4 percent in 1995. Near the end of the period, however, these gains were offset by the assassination on September 28 of Jose Francisco Ruiz Massieu, general secretary of the PRI. The dollar--peso exchange rate closed the quarter at NP3.3930, little changed from where it opened.

THE CANADIAN DOLLAR APPRECIATES AS POLITICAL UNCERTAINTY RECEDES

During the quarter, the Canadian dollar strengthened against the U.S. dollar as market concerns over Quebec separatism receded, allowing investors to turn their attention to Canada's favorable mix of strong growth and low inflation. The U.S. dollar opened the period at C$1.3791. The Canadian dollar began to appreciate in early August as opinion polls suggested that even though the Parti Quebecois (PQ) was likely to win Quebec's September 12 provincial election, support for its separatist platform was more limited. By the eve of the election, the Canadian dollar had firmed to about C$1.3670, although spreads on Canadian interest rates over equivalent U.S. rates had narrowed considerably. The Canadian dollar firmed suddenly on September 13, the day after the election, as the PQ's narrower-than-expected victory over the incumbent Liberal Party and its inability to garner 50 percent of the popular vote suggested that a referendum on Quebec independence would probably not succeed. Buoyed by foreign demand for Canadian financial assets, the Canadian dollar traded to a high of C$1.3400 in the days after the election and then closed at C$1.3430. Canadian interest rates declined further, and by late September Canadian short-term rates were below U.S. rates.

TREASURY AND FEDERAL RESERVE FOREIGN EXCHANGE RESERVES

At the end of the period, the current value of the foreign exchange reserve holdings of the Federal Reserve and the Treasury Department's Exchange Stabilization Fund (ESF) were $23.1 billion and $20.4 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 securities issued by foreign governments. As of September 30, the Federal Reserve and the ESF held, either directly or under repurchase agreement, $12.4 billion and $12.0 billion respectively in foreign government securities.

3. Federal Reserve reciprocal currency arrangements

Millions of dollars

                                      Amount of
          Institution                  facility,       Drawings
                                    Sept. 30, 1994   during period
Austrian National Bank                     250            0
National Bank of Belgium                 1,000            0
Bank of Canada                           2,000            0
National Bank of 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                           3,000            0
Netherlands Bank                           500            0
Bank of Norway                             250            0
Bank of Sweden                             300            0
Swiss National Bank                      4,000            0
Bank for International Settlements
Dollars against Swiss francs               600            0
Dollars against other authorized

     European currencies                 1,250            0

Total                                   32,400            0

(1.)The charts for the report are available on request from Publications Services, Mail Stop 127, Board of Governors of the Federal Reserve System, Washington, DC 20551.

(2.)The dollar's movements on a trade-weighted basis in terms of other G-10 currencies are measured using an index developed by staff at the Board of Governors of the Federal Reserve System.