July - September 1996

During the quarter, the dollar appreciated 1.6 percent against the Japanese yen, 0.1 percent against the German mark, and 0.1 percent on a trade-weighted basis against other G-10 currencies. Over the quarter, the dollar was supported by expectations that the Federal Reserve would tighten monetary policy, in contrast to expectations for steady policy in Germany and Japan. In addition, sentiment for the prospect of broad participation in the European Monetary Union shifted from doubt early in the quarter to growing confidence late in the quarter, lending support to the dollar against the mark. 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) received a $7 billion repayment from the United Mexican States related to drawings by Mexico under the medium-term swap facility with the ESF. An additional $3.5 billion remained outstanding under the facility.


For the period as a whole, foreign exchange markets were relatively stable. The average daily trading range of the dollar was substantially less than the ranges observed in the previous year. On average, the dollar traded in a daily range of 0.6 percent against both the mark and yen. This compares with daily dollar ranges of 1.1 percent against the mark and 1.4 percent against the yen in the third quarter of 1995. Additionally, implied volatility on dollar-mark and dollar-yen one-month options generally maintained the low levels of the previous quarter. However, the period was marked by a few brief episodes of sharp dollar movements. The dollar's largest one-day move occurred early in the period on July 16. On this day, the dollar traded in a 3.1 percent range against the mark, implied volatility on one-month dollar-mark options spiked higher, and prices of risk reversals (1) indicated a rise in the perceived risk of a further significant dollar decline. As with other sharp dollar moves over the period, the dollar's trading ranges over subsequent days fell back toward the period's average, implied volatility on dollar-mark options reverted toward record-low levels, and risk reversal prices moved closer to neutral.


Expectations for a Federal Reserve tightening shifted throughout the period. Signs of strong U.S. economic growth, tightening labor markets, yet benign inflation data, made the near-term interest rate outlook uncertain.

Early in the quarter, the dollar reached a twenty-nine-month high against the yen of ¥111.19 while holding above DM 1.52 against the mark following the strong U.S. June nonfarm payroll report, which led many market participants to anticipate an imminent Federal Reserve tightening. Subsequently, U.S. stock prices declined sharply and a liquidation of long dollar positions ensued. On July 16, the dollar depreciated from opening prices of DM 1.5145 and ¥110.22 to a low of DM 1.4695 and ¥108.27 before partially recovering to close the day at DM 1.4844 and ¥109.32.

Expectations of a near-term Federal Reserve tightening were scaled back following Chairman Greenspan's Humphrey-Hawkins testimony in July. Market participants appeared to focus on his comments about the potential for an economic slowdown in the second half of the year. Subsequent benign inflation reports further diminished expectations for a tightening, and in the event, the August FOMC meeting ended with no announced change in policy.

In September, expectations began to build anew for a Federal Reserve tightening at the September 24 meeting. The August nonfarm payroll data continued to show robust employment growth. The dollar steadily recovered all of its losses against the mark and yen, supported by expectations of higher U.S. short-term interest rates as well as by ongoing strength in the U.S. stock market in September.

The FOMC's decision to keep policy unchanged at the September 24 meeting surprised many market participants. Although the dollar declined sharply on the day of the announcement, it more than recovered its losses the following day. Despite the FOMC's decision to leave policy unchanged, some market expectation for a tightening by year-end remained.


Early in the period, the release of May German industrial production and orders data indicating a third consecutive month-to-month rise in each series contributed to market perceptions that the German economic recovery would preclude further Bundesbank interest rate cuts and that market rates would rise by year-end. The perception that German rates had bottomed contributed to the decline in the dollar against the mark in mid-July, when declines in U.S. equity prices also weighed on the dollar.

Subsequently, however, market expectations of Bundesbank policy gradually shifted as the mark appreciated against the dollar, growth in the Bundesbank's M3 monetary aggregate decelerated, and German business sentiment deteriorated. Also, Bundesbank officials made periodic comments that held open the possibility of further reductions in the Bundesbank's key repurchase rate. Long-term interest rate differentials between the U.S. and Germany widened further in favor of the dollar, and contributed to the stabilization of the dollar after its sharp decline in mid-July.

At its last meeting before the summer recess on July 25, the Bundesbank disappointed market expectations, leaving its repo rate unchanged at 3.30 percent, and the German mark rose sharply. The dollar fell from an opening price of DM 1.4905 to a low of 1.4723 on the announcement.

However, in a largely unanticipated move, at its August 22 meeting the Bundesbank cut its repo rate by 30 basis points to 3.00 percent. The dollar appreciated after the Bundesbank's decision, as interest rate differentials between the U.S. and Germany widened further in favor of the dollar. After the reduction, market participants generally came to expect that monetary policy in Germany would remain stable through the early part of 1997. Reflecting that sentiment, implied yields on three-month Euromark futures contracts through March 1997 declined to levels only slightly above cash rates.

The Bundesbank's cut fostered an impression among many market participants that the Bundesbank was motivated, at least in part, to ease pressures on other EU members to meet the economic convergence criteria of the Maastrict Treaty. In addition, the anticipated pressures on European currencies during the release of government budgets across Europe did not materialize. This led to sales of German marks against higher-yielding European currencies. In September, the dollar steadily climbed back above DM 1.52.


Early in the period, most market participants believed that a hike in Japanese interest rates would soon follow any tightening by the Federal Reserve. This assumption came into question, however, as official commentary and the Bank of Japan's quarterly outlook released in late July suggested that the economy had not achieved a "self-sustaining" recovery. A sharp decline in Japanese stock prices in late August further contributed to the belief that the Bank of Japan would not raise rates in the near term.

Additional evidence accumulated to suggest that Japan's economic recovery remained fragile. On August 28, a weak August Tankan report showed an unexpected deterioration in business confidence. In mid-September, the second quarter GDP report showed an annualized quarter-on-quarter decline of 2.9 percent. On the last day of the quarter, the dollar reached a two-and-a-half year high of ¥111.68 against the yen, boosted by expectations that Japanese investors would increase their investments in higher-yielding foreign assets in the second half of the Japanese fiscal year.

The market's reaction to trade data released during the third quarter was mixed. Early in the period, declines in Japan's trade surplus, the U.S. trade deficit, and the U.S.-Japanese bilateral deficit, albeit all at a slower pace than the rate of decline in previous quarters, supported the dollar. At the end of the quarter, U.S. July trade data indicating a widening overall U.S. deficit as well as a larger bilateral deficit with Japan, prompted a sharp but temporary decline in the dollar.


In Canada, low inflation, a firming Canadian dollar, and steady U.S. monetary policy allowed interest rates to continue their downward trend. The Bank of Canada reduced its overnight call money range by a total of 75 basis points over the period. The mid-point of the target range ended the quarter at 4.00 percent, about 125 basis points below the Federal Funds rate. By the end of the period, positive yield spreads between Canadian government bonds and comparable U.S. Treasuries existed only beyond the five-year maturity sector. The spread between the benchmark ten-year Canadian government bond and the ten-year U.S. Treasury note narrowed from 99 to 43 basis points over the period.


The peso strengthened over the quarter despite periodic concerns about a near-term interest rate hike in the United States. Market participants became optimistic about the strength of Mexico's economic recovery, following a 7.2 percent rise in its second quarter GDP. Domestic interest rates fell, while Mexican Brady debt spreads over U.S. treasuries fell from 669 to 510 basis points.

Mexico successfully raised funds in the international capital markets in four different issues in the third quarter. In July, Mexico issued $6 billion in five-year floating rate notes at a 200 basis point spread over Libor, and in September, it placed a $1 billion twenty-year Eurobond issue at narrower than expected spreads over U.S. Treasuries. On August 5, Mexico repaid in advance $7 billion of the $10.5 billion outstanding under the U.S. Treasury's Exchange Stabilization Fund (ESF) medium-term swap facility. Of this amount, $5 billion was used to repay fully the two swaps that had been drawn in April and May of 1995, and $2 billion was used to pay down 80 percent of the July 1995 drawing. The repayments reduced the amount outstanding from these swaps to $3.5 billion.


At the end of the quarter, the foreign currency reserve holdings of the Federal Reserve System and the ESF were valued at $19.4 billion and $15.9 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 September 30, outright holdings of government securities by U.S. monetary authorities totaled $6.4 billion and included investments in Japanese treasury bills and German government securities.

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 $11.0 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.


1. A risk reversal is an option position consisting of a written put and a purchased call that mature on the same date and are equally out-of-the-money. The price of a risk reversal indicates whether the dollar call or the dollar put is more valuable. If the dollar call is at a premium, the market is willing to pay more to insure against the risk that the dollar will rise sharply. If the dollar put is at a premium, the market is willing to pay more to insure against the risk that the dollar will fall sharply. *

* * * This report, presented by Peter R. Fisher, 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 July 1996 through September 1996. Christine Hall was primarily responsible for preparation of the report.