Treasury and Federal Reserve foreign operations.

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

The dollar appreciated modestly against most major currencies during the November-January period. It rose 2.9 percent against the German mark, 0.1 percent against the Japanese yen, and 0.5 percent on a trade-weighted basis.(2) The U.S. monetary authorities did not undertake any intervention operations during the period.

THE DOLLAR ENDS THE PERIOD VIRTUALLY UNCHANGED AGAINST THE YEN

After opening at 108.64 yen on November 1, the dollar rose against the yen in thin year-end markets, reaching a high of 113.55 yen before coming down to end the period unchanged. Initially, the dollar rose as market participants turned their attention to Japan's lingering recession and to the prospect of interest rate differentials moving in favor of the dollar. This shift in focus was prompted by continued weakness in Japanese money supply growth, employment, industrial production, and retail sales. Moreover, Japanese equity prices dropped sharply in November--with the Nikkei stock index failing nearly 17 percent over the course of the month-- and remained volatile throughout December. Growing pessimism over the economic outlook for Japan, as well as the uncertain prospects for the Hosokawa government' s long-awaited fiscal stimulus package, helped fuel expectations of an additional cut in the Bank of Japan' s Official Discount Rate (ODR).

Over the course of December, trading activity in the dollar-yen exchange market started to ebb as first corporate and then interbank participants pulled back from the market ahead of the year-end holidays. Japanese exporters, who regularly sell dollars to the market to hedge their foreign currency receivables, were notably absent toward the end of the month. In this environment, market conditions were increasingly characterized by the dominance of technically oriented traders who bought up the U.S. currency in anticipation of further dollar gains, and the dollar rose gradually through December from a low of 107.37 yen to a high of 112.05 yen.

In late December, Treasury Secretary Bentsen was asked whether he saw a need to intervene in the foreign exchange market to stem the yen's decline. He responded that he did not think intervention would be necessary but rather thought that the foreign exchange market would focus on Japan's substantial trade surplus when determining the relative value of the dollar and the yen. Secretary Bentsen expressed concern that Japan was not meeting its commitment to achieve domestic demand-led growth and a significant reduction in its external surplus. He expanded on this view in early January when he said that the proper way for Japan to address its economic imbalances was through a combination of effective fiscal stimulus and market-opening measures, not through a depreciation of the yen.

The dollar reached its period high of 113.55 yen on January 5 but soon drifted lower when expected movements in interest rates failed to materialize. Market participants turned their attention to the shifting fortunes of Japanese political reform and to bilateral trade talks with the United States, but they were unable to develop a lasting view on how the success or failure of these two initiatives would affect exchange rates. Reflecting the market's uncertainty about the near-term direction of the dollar against the yen, the implied one-month option volatility for the dollar-yen exchange rate spiked higher in the second half of January. At the same time, foreign investors purchased the equivalent of $10.5 billion in Japanese equities during January; these flows contributed to a sharp rebound in Japanese stock prices and helped support the yen.

The upper house of the Japanese Diet passed Prime Minister Hosokawa's political reform bill on January 29, permitting the government to turn its attention to other policy issues. As the period came to a close, U.S.-Japanese trade talks were continuing and the Japanese government was reportedly at work on a record stimulus package for the economy. Reflecting the positive implications of such a package for Japanese domestic demand growth, the Nikkei surged nearly 8 percent on the last day of the period, and expectations of additional interest rate cuts in Japan receded even further. These factors helped strengthen the yen, and the dollar closed at 108.65 yen on January 31.

DOLLAR APPRECIATES MODESTLY AGAINST THE MARK

During November and most of December, the dollar was relatively stable against the German mark, trading in a narrow range around the DM1.70 level. Market sentiment toward the dollar was generally positive, however, with dealers taking note of the increasingly divergent paths of the U.S. and German economies. In this environment, market participants began to anticipate a fairly rapid convergence of short-term German and U.S. interest rates. The Bundesbank, which had surprised the foreign exchange market in late October, when it cut its discount and Lombard rates 50 basis points, trimmed its key money market repurchase rate from 6.40 percent at the start of the period to 6.25 percent on December 1. At its December 2 council meeting, the Bundesbank announced a prefixed rate of 6.0 percent for the next five weekly auctions of fourteen-day repurchase agreements. Market participants generally interpreted this move as an effort to nudge short-term interest rates lower while also dampening speculation of further monetary easing.

The dollar broke out of its trading range in late December, jumping four pfennigs higher in the last three days of the month. Dealers expressed initial skepticism over the rise, which occurred in thin year-end markets. Nonetheless, the dollar subsequently extended its gains to reach a twenty-eight-month high of DM1.7562 on January 14. As the dollar moved higher, it gained broad support from a series of U.S. and German statistical releases-- notably retail sales, factory orders, and the purchasing managers index for the United States, and industrial production, unemployment, and real gross domestic product for Germany that further contrasted economic conditions in the two countries. Well-publicized financial setbacks at two large German companies, along with a modest selloff in German bonds and equities, added to the market's perception of a still fragile German recovery.

During the latter pan of January, the dollar settled into a new trading range against the mark. Expectations of near-term volatility in the dollar-mark exchange rate dropped off sharply, as the implied one-month option volatility fell from nearly 12 percent in early January to less than 9 percent at month-end. While market rumors of central bank sales helped cap the dollar's rise, movements in actual and expected interest rate differentials also weighed on the U.S. currency. At its two January meetings, the Bundesbank Council kept its repurchase rate fixed at 6.0 percent, as it disappointed the market and further deflated expectations about the pace of German interest rate cuts. Similarly, a perceived lack of inflationary pressures in the United States led dealers to rethink their expectations of a near-term hike in short-term U.S. interest rates. During most of January, therefore, differentials in three-month Eurodeposit rates, as well as those in the expected three-month deposit rates implied by futures prices, moved in the mark' s favor. The dollar closed the period on January 31 at DM1.7338.

OTHER OPERATIONS

As of the end of January, cumulative valuation gains on outstanding foreign currency balances were $2,868.4 million for the Federal Reserve and $2,513.0 million for the Treasury's Exchange Stabilization Fund (ESF). There were no realized profits or losses for the quarter.

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 liquidity and credit quality. A portion of the balances is invested in securities issued by foreign governments. As of the end of January, the Federal Reserve and the ESF held either directly or under repurchase agreements $10,740.5 million and $10,436.2 million respectively in foreign government securities valued at end-of-period exchange rates.

  1.  Federal Reserve reciprocal currency arrangements
      Millions of dollars
                                                Amount of
                             Institution        facility,
                                             January 31, 1994

  Austrian National Bank ..................      250
  National Bank of Belgium ................    1,000
  Bank of Canada ..........................    2,000
  National Bank of Denmark ................      250
  Bank of England .........................    3,000
  Bank of France ..........................    2,000
  Deutsche Bundesbank .....................    6,000
  Bank of Italy ...........................    3,000
  Bank of Japan ...........................    5,000

  Bank of Mexico ..........................      700
  Netherlands Bank ........................      500
  Bank of Norway ..........................      250
  Bank of Sweden ..........................      300
  Swiss National Bank .....................    4,000

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

  Total ...................................   30,100

  2.  Net profits or losses (-) on U.S. Treasury
  and Federal Reserve foreign exchange operations(1)

  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 October 31, 1993 .........       3,368.5      2,839.0

Realized profits and losses,
November 1, 1993-January
31, 1994 .......................           0.0          0.0
Valuation profits and losses on
outstanding assets and liabilities ]
as of January 31, 1994 .........        2,868.4     2,513,0
  (1)  Data are on a value-date basis.

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.