TREASURY AND FEDERAL RESERVE FOREIGN EXCHANGE OPERATIONS

April - June 1996

During the second quarter of 1996, the dollar traded in a relatively narrow range against the Japanese yen, fluctuating between Y104 and Y110. Against the mark, the dollar appreciated early in April, then proceeded to trade between DM 1.51 and DM 1.55 for the duration of the quarter. Throughout the period, the dollar was supported by expectations of an increase in U.S. interest rates by the end of 1996. Meanwhile, evolving market views of the likely course of German and Japanese monetary policy contributed to fluctuations within the trading range. Over the quarter, the dollar appreciated 3.2 percent against the German mark, 2.2 percent against the Japanese yen and 1.6 percent on a trade-weighted basis against other G-10 currencies. 1 The U.S. monetary authorities did not undertake any intervention operations in the foreign exchange market during the quarter.

In the final month of the quarter, the dollar became increasingly entrenched in tight ranges, pinned between DM 1.51 and DM 1.54 and between Y107.60 and Y110. After the first week of June 1996, the dollar's Friday closing levels against the mark and yen never varied more than 1 percent from the preceding week's close. In this environment, implied volatility on dollar-mark and dollar-yen one-month options declined to levels seldom seen. The probability distribution of future exchange rates implied by one-month currency option prices became notably tighter during the quarter, reflecting expectations of lower exchange rate volatility and market participants' greater willingness to bear the risks of selling options.

EXPECTATIONS OF A HIKE IN U.S. RATES SUPPORT THE DOLLAR

Throughout the quarter, U.S. economic data releases led many market participants to anticipate a near-term Federal Reserve tightening. Most notably, nonfarm payroll reports for March and April provided evidence that the U.S. labor market remained strong. Initial reports that first-quarter GDP had grown at a 2.8 percent year-on-year rate, although later revised down, reinforced the perception of strength in the economy. Expectations of monetary tightening were reflected in forward rates, with three-month rates on December Eurodollar futures rising by nearly 60 basis points from April 1 to the middle of June.

The perception of underlying economic strength in the United States prompted buying of dollars during episodes of dollar weakness, providing support for the dollar at the bottom of its trading range. In the last week of the quarter, expectations of an imminent Federal Reserve tightening were sharply scaled back after a number of press and market research reports suggested that a near-term change in policy was unlikely. The dollar had little reaction to these late developments, with foreign exchange market participants focusing instead on developments in Germany and Japan.

Shifting expectations about U.S. monetary policy caused sporadic disturbances in U.S. asset markets. Declines in U.S. stock and bond prices, which had weighed on the dollar in previous periods, did not significantly weaken the dollar during this quarter.

AGAINST THE MARK, THE DOLLAR BENEFITS IN APRIL AND MAY FROM EXPECTATIONS OF GERMAN MONETARY EASING

Early in the period, expectations of a further easing of money market rates by the German Bundesbank were supported by official policy actions. On April 18, the Bundesbank announced it would cut its discount and Lombard rates, effectively lowering the range within which German money market rates fluctuate. Although the key repurchase rate remained fixed at 3.30 percent, the change in official rates spurred expectations that cuts in the repurchase rate would follow in subsequent weeks.

These perceptions were bolstered by weak economic data and by several German economic institutes' downward revisions of projections for 1996 growth. Western German consumer price index data released in late April confirmed that inflationary pressures remained subdued; together with Bundesbank officials' hints that scope for easing existed, this development appeared to reinforce the prospects of an ease.

In this environment, the dollar broke above the trading range in which it had been contained for much of March. After decisively breaking DM 1.50 on April 11, the U.S. currency continued to appreciate, closing at a high for the quarter of DM 1.5470 on May 28.

IN JUNE, THE DOLLAR RETREATS FROM ITS HIGHS AGAINST THE MARK AS HOPES FOR BUNDESBANK EASING FADE

The Bundesbank did not, in fact, reduce money market rates during the quarter, and the repurchase rate remained fixed at 3.30 percent. Anticipation of additional Bundesbank easing during the cycle had begun to fade by late May as indicators of improved business sentiment were released. Stronger than expected industrial orders and continued growth of M3 well above the 7 percent ceiling of the Bundesbank's target range in April and May further dampened expectations. By mid-June, prices in German credit markets began to reflect an expectation of Bundesbank rate hikes by the autumn of 1996, and forward rate agreement (FRA) rates for three-month Euromark deposits three months out moved sharply higher than cash rates, after having traded in a range roughly equal to or lower than that of cash rates for most of the quarter.

Dissipating expectations of German monetary easing weighed on the dollar-mark exchange rate. The dollar's continued failure to break through DM 1.55 prompted market participants to scale back long dollar positions, and the U.S. currency retreated from its highs in May to close at a low for June of DM 1.5122 on June 18. Apparently capped at DM 1.55 but well supported above DM 1.51, the dollar proceeded to trade in a narrow corridor, and implied volatility on one-month dollar-mark options approached record lows. At the same time, while the dispersion of the probability distribution of the future dollar-mark exchange rate implied by currency options declined, it became increasingly skewed toward a weaker dollar.

EXPECTATIONS OF A HIKE IN JAPANESE INTEREST RATES WEIGH ON THE DOLLAR-YEN EXCHANGE RATE EARLY IN THE QUARTER

Early in the quarter, the dollar fell against the yen as sentiment grew that the Bank of Japan's accommodative monetary policy stance could end as early as the later part of the quarter. This perception was supported by data released in April suggesting recovery in the retail, manufacturing, and housing sectors of the economy. Official comments also fueled interest rate anxieties. Market participants were particularly wary of April comments from Bank of Japan Governor Matsushita suggesting that rising rates were "natural" in a recovering economy and noting the link between Japan's easy money policies of the 1980s and the ensuing "bubble economy."

At the peak of these concerns at the end of April, with December Euro-yen futures contracts reflecting three-month rates nearly 90 basis points above cash rates, the dollar traded to the bottom of its range for the quarter. The dollar briefly traded below Y104, and dollar-yen one-month implied options volatility spiked to an 11.25 percent high for the quarter. The dollar was supported at these levels by a market perception that the Japanese monetary authorities would not tolerate a weaker dollar, because this might jeopardize Japan's economic recovery.

THE DOLLAR RECOVERS AGAINST THE YEN AS MARKET PARTICIPANTS VIEW NEAR-TERM JAPANESE MONETARY TIGHTENING AS UNLIKELY

By early June, anticipation of an imminent Japanese rate hike began to ebb. Analysts concluded that ongoing problems in Japan's financial sector and the absence of compelling evidence that Japan's economic recovery could sustain itself without fiscal stimulus precluded such a step. That perception became more prevalent after Bank of Japan Governor Matsushita said on May 15 that Japan's recovery was not "self-sustaining." The Bank of Japan's Tankan survey, released on June 7, was somewhat stronger than expected but still too weak to alter these expectations. Forward rates declined in this environment, and the dollar recovered against the yen, appreciating from its early-May lows to trade above Y109 in early June.

The June 18 announcement that Japan's annualized first-quarter GDP growth rate was 12.7 percent briefly revived speculation that a Bank of Japan tightening might be imminent, and the dollar traded off its highs to below Y108 in tandem with a sell-off in Japanese credit markets. The dollar and Japanese bonds recovered, however, as market participants ultimately concluded that the strong GDP figure would not in itself prompt a rate hike. In the quarter's final week, remaining anticipation of a Bank of Japan tightening by summer's end subsided with the release of weaker than expected industrial production figures and reports that unemployment had surged in May to a record-high 3.5 percent. December Euro-yen contracts ended the quarter reflecting three-month rates only 53 basis points above cash rates, and the dollar rose to close the quarter at a twenty-nine-month high of Y109.65.

As in preceding quarters, Japan reported declining trade surpluses and sharp contractions of its trade surplus with the United States. These data releases provided support for the dollar throughout the period, although immediate reaction to individual data releases was muted. Data for March, April, and May indicated that, in each month, the bilateral surplus had declined by over 30 percent from the previous year's level.

THE MEXICAN PESO WEAKENS AMID CONCERNS OVER A POSSIBLE U.S. RATE HIKE

Through April and May, the Mexican peso traded against the dollar in a steady range between NP 7.40 and NP 7.55 despite a backup in U.S. bond yields. In June, growing concerns about a possible U.S. monetary tightening sparked a correction, pushing the peso out of its recent range to trade above NP 7.60 against the dollar.

Toward the end of the period, markets reacted positively to the Mexican authorities' announcement that they intended to repay in August a substantial portion of the $10.5 billion outstanding under the U.S. Treasury's Exchange Stabilization Fund (ESF) medium-term swap facility, an announcement that came amid continued positive news on the Mexican economy. Waning expectations of an imminent Federal Reserve tightening in the final week of the quarter also benefited the peso, and the currency recovered partially, closing the quarter at NP 7.58.

TREASURY AND FEDERAL RESERVE FOREIGN EXCHANGE RESERVES

The U.S. monetary authorities did not undertake any intervention operations this quarter. At the end of the quarter, the foreign currency reserve holdings of the Federal Reserve System and the ESF were valued at $19.5 billion and $16.1 billion, respectively, and consisted of German marks and Japanese yen.

The U.S. monetary authorities invest all 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 significant portion of these balances is invested in German and Japanese government securities held either directly or under repurchase agreement. As of June 30, outright holdings of government securities by U.S. monetary authorities totaled $4.6 billion and included investments in Japanese treasury bills and German government bonds.

Japanese and German government securities held under repurchase agreement are arranged either through transactions executed directly in the market or through agreements with official institutions. Government securities held under repurchase agreements by the U.S. monetary authorities totaled $12.3 billion at the end of the quarter. Foreign currency reserves are also invested in deposits at the Bank for International Settlements and in facilities at other official institutions.

In addition, the ESF held $10.5 billion equivalent in nonmarketable Mexican government securities in connection with the ESF's medium-term swap arrangement.

ENDNOTE 1. The dollar's movements on a trade-weighted basis against ten major currencies are measured using an index developed by staff of the Board of Governors of the Federal Reserve System.

This report, presented by Peter R. Fisher, Executive Vice President, Federal Reserve Bank of New York, and Manager, System Open Market Account, describes the foreign exchange operations of the U.S. Department of the Treasury and the Federal Reserve System for the period from April 1996 through June 1996. Daniel Katzive was primarily responsible for preparation of the report.