Treasury and Federal Reserve
Foreign Exchange Operations

January-March 1996

During the first quarter of 1996, the dollar appreciated 3.9 percent against the Japanese yen, 3.0 percent against the German mark, and 2.1 percent on a trade-weighted basis against other G-10 currencies.1 The dollar strengthened in the first weeks of the new year, reaching its highs for the quarter of DM 1.4945 on January 25 and ¥107.57 on January 31. After briefly weakening in February, the dollar proceeded to trade in a narrow range. It closed the quarter at DM 1.4764 and ¥107.24. The U.S. monetary authorities did not undertake any intervention operations in the foreign exchange market during the quarter. However, the U.S. Treasury's Exchange Stabilization Fund (ESF) and the Federal Reserve System did receive final repayments from Mexico on the remaining $650 million balances outstanding under each of their respective short-term swap arrangements. An additional $10.5 billion remains outstanding under the ESF's medium-term swap facility.

THE DOLLAR STRENGTHENS AT THE OUTSET OF THE NEW YEAR

Early in the year, the dollar appreciated against the German mark and other European currencies on the widespread perception that monetary easing in Europe would proceed at a faster pace than in the United States. This expectation was bolstered by the release of weak German economic data in January: the seasonally adjusted west German unemployment rate for December rose to 8.6 percent, and forecasts for 1996 real growth in German GDP began to be revised downward to below 2.0 percent.

Against the yen, the dollar was supported by indications of a continued narrowing of the U.S.-Japan current account imbalance. Trade statistics released in Japan showed that Japan's November current account surplus had fallen 17.1 percent year-over-year and confirmed that Japan's 1995 current account surplus was the lowest in four years. Similarly, U.S. trade data indicated that in October 1995 the U.S. trade deficit with Japan, while slightly higher than in September 1995, had fallen by almost $2 billion dollars from its year-ago level.

Early in the quarter, the dollar also indirectly benefited against the yen from the market perception of a broad-based revival of investors' risk appetite and demand for higher yields. This dynamic served to support the currencies and credit markets of the higher-yielding European countries, including Italy, Sweden, and Spain, at the expense of lower-yielding currencies, such as the Japanese yen. The generalized weakness in the yen helped support the dollar-yen exchange rate.

Investors also became more optimistic about the outlook for the dollar following the end of the U.S. government shutdown in December and a subsequent easing of market concern about the budget impasse. Finally, comments made by German and other Group of Seven (G-7) officials around the time of the January G-7 meeting of finance ministers and central bank governors suggested a preference for a stronger U.S. currency.

MONETARY POLICY EXPECTATIONS CHANGE AND THE DOLLAR DECLINES

In February, bond markets in Germany and Japan weakened amid a broad reassessment of interest rate expectations before recovering later in the quarter. At the same time, U.S. Treasury bond yields also rose.

In the United States, credit markets were hurt by a shift in the budget debate. Negotiations on balancing the federal budget appeared unlikely to progress further, while the commencement of the 1996 presidential campaign focused attention on the prospects for stronger economic growth. During February, the yield on the benchmark thirty-year Treasury bond rose by nearly 50 basis points. Weakness in the U.S. bond market contributed to a weakening of the dollar as market participants anticipated that the bond market's performance would prompt foreign investors to liquidate positions in dollar-denominated securities.

Meanwhile, at the beginning of February, the German Bundesbank announced that it would fix its repurchase rate at 3.30 percent. The announcement suggested to some market participants that the Bundesbank might be at or near the end of its easing cycle. These concerns were magnified by widespread rumors that February data would indicate that German M3 had risen at a rate well above the Bundesbank's target range in January. The prospect that German economic growth would resume and that interest rates would not continue to fall prompted strengthening of the mark.

Also in early February, a report of strong Japanese housing starts and higher than expected Japanese industrial production prompted market participants to wonder whether Japan's accommodative monetary policy stance might soon end, despite continued generous liquidity injections by the Bank of Japan. Then, on February 15, comments by Japanese Finance Minister Kubo indicating that low interest rates were hurting senior citizens were interpreted by market participants as confirming that Japan's official rates would soon rise. This sentiment contributed to a broad-based unwinding of short yen positions against the U.S. dollar and other major currencies. The dollar weakened against the yen and the mark, reaching February lows of DM 1.4411 on February 19 and ¥103.35 on February 27. Against the yen, the dollar was supported by widespread reports of intervention by the Japanese monetary authorities and the subsequent perception that Japanese monetary authorities did not wish to see renewed strength of the yen.

THE DOLLAR RECOVERS AND PROCEEDS TO TRADE IN A TIGHT RANGE
THROUGH THE END OF THE QUARTER

Concerns about an end to German monetary easing began to diminish after the release of the January M3 report, which, although above the Bundesbank's target range, was lower than the market's worst fears. In early March, the release of negative fourth-quarter GDP figures and high February unemployment data in Germany as well as continuing evidence of subdued inflationary pressures helped revive expectations of further German interest rate reductions.

Similarly, in Japan, the March 1 release of a somewhat weaker than expected Tankan survey by the Bank of Japan indicated that the Japanese economy was recovering more slowly than previously anticipated by market participants. This development served to unwind market expectations of a near-term change in Japanese monetary policy and caused yields implied by 1996 Euroyen futures contracts to fall as much as 33 basis points.

On March 8, it was reported that U.S. February nonfarm payrolls had grown by 705,000, an increase more than twice as large as consensus expectations, and that the unemployment rate had fallen to 5.5 percent. The strong data led to a reassessment of expectations for future Federal Reserve policy and suggested to many that stronger growth in the United States would move interest rate differentials between the United States and Japan and between the United States and Germany in favor of the dollar.

The combined effect of the data in the three markets was to resurrect, at least partially, the relative growth scenarios that had been favorable to the dollar early in the year. The dollar recovered against the mark and the yen and proceeded to trade in a narrow range for the remainder of the quarter, firming against the yen as trading thinned in the final week of the Japanese fiscal year. The market consensus that Japanese exporters had largely hedged their dollar revenues well in advance of the conclusion of the Japanese fiscal year helped prevent the heavy dollar selling that was evident in March in recent years.

NORTH AMERICAN MARKETS ARE STABLE

Canadian credit markets performed well during the quarter, with the spread between Canadian and U.S. government ten-year benchmark bond yields falling sharply amid favorable fiscal developments in Canada and diminished perceptions of political risk. The Canadian dollar closed the quarter 0.5 percent stronger against the U.S. dollar.

Mexican markets also stabilized, largely ignoring volatility in U.S. equity and credit markets. The Mexican peso appreciated by 2.3 percent against the dollar, despite weakening in February, and overnight interest rates fell by nearly 900 basis points to 35 percent. Shifting investor appetites -- fueled by expectations for moderating inflation, signs of improving economic fundamentals, and increasing confidence in Mexican monetary policy -- supported the peso.

GOLD PRICES RISE

Gold prices reached their highest levels in nearly six years, trading as high as $418.40 per ounce. Three factors appear to have fueled the rally: strong demand from physical end-users in Asia, low opportunity costs for holding the metal as global interest rates declined, and reduced forward sales by producers. Later in the quarter, these price gains were partially reversed as high prices spurred additional sales. The price of the metal closed the quarter $8.35 higher, at $395.45 per ounce.

MEXICAN SWAP ACTIVITY

On January 29, Mexico made final repayment on its short-term swap arrangements with the U.S. monetary authorities. A total of $1.3 billion was repaid, divided evenly between the Federal Reserve System and the ESF. On January 31, 1996, the special $3 billion swap facility established by the Federal Reserve System on February 1, 1995, expired according to its original terms without being renewed.

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 current values of the German mark and Japanese yen reserve holdings of the Federal Reserve System and the ESF were $20.0 billion and $16.5 billion, respectively. The U.S. monetary authorities invest all of 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 March 31, outright holdings of government securities by U.S. monetary authorities totaled $3.6 billion and included investments in Japanese treasury bills and German government bonds.

Japanese and German government securities are also held under repurchase agreement 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 $14.3 billion. In addition to government securities, 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 January 1996 through March 1996. Daniel Katzive was primarily responsible for preparation of the report.