Treasury and Federal Reserve foreign exchange operations - dollar values against foreign currencies in fourth quarter 1995

Federal Reserve Bulletin, March, 1996 by Soo J. Shin

This quarterly report describes Treasury and System foreign exchange operations for the period from October through December 1995. It was presented by Peter R. Fisher, Executive Vice President, Federal Reserve Bank of New York, and Manager for Foreign Operations, System Open Market Account. Soo J. Shin was primarily responsible for preparation of the report.(1)

During the fourth quarter of 1995, the dollar appreciated modestly, strengthening 3.7 percent against the Japanese yen and 0.5 percent against the German mark. The dollar also rose 0.6 percent on a trade-weighted basis against other Group of Ten (G-10) currencies.(2) Toward the end of the quarter, the dollar consolidated in increasingly narrow ranges, and trading activity declined as market participants reduced their appetite for risk before year-end. The U.S. monetary authorities did not undertake any intervention operations during the quarter. In other operations, the U.S. Treasury's Exchange Stabilization Fund (ESF) and the Federal Reserve System received repayments from Mexico of $350 million each on their respective short-term swap arrangements, and

they renewed the same arrangements in the amount of $650 million each for an additional ninety days.

SUBDUED YEAR-END MARKET ACTIVITY

The dollar opened the quarter at DM 1.4273 and 99.55[yen] and proceeded to fluctuate between DM 1.3808 and DM 1.4550 and 99.28[yen] and 104.12[yen] during the period. In the environment of limited risk-taking witnessed during the quarter, countervailing political and economic developments in the United States and other countries helped keep the dollar in these relatively narrow ranges. The dollar closed the quarter at DM 1.4339 and 103.20[yen].

GRADUAL APPRECIATION OF THE DOLLAR AGAINST THE YEN

The dollar modestly extended its gains against the yen from the previous quarter as the wide differential in interest rates and signs of reduced trade imbalances between the United States and Japan continued to favor the dollar. In addition, the prospects for fiscal consolidation in the United States combined with a better U.S. economic outlook relative to other major economies also helped to support market sentiment for the dollar.

As in the previous quarter, market participants continued to anticipate increased private capital outflows from Japan as a result of low domestic interest rates and the sizable amount of domestic debt maturing in the fourth quarter. The substantial decrease in Japan's current account surplus also contributed to the negative sentiment toward the yen. Furthermore, most Japanese exporters were perceived to be absent from the marketplace, having already filled their hedging requirements. On the other hand, Japanese institutional investors reportedly purchased dollars in conjunction with acquisitions of U.S. government securities. Amidst these factors the dollar rose to the quarter's high of 104.12[yen] on November 2.

The dollar also benefited, in part, from market perceptions of a weak Japanese banking system and of a lack of transparency in Japanese bank accounting practices and disclosures of nonperforming loans. After several Japanese banks were downgraded by a credit rating agency, short-term funding costs for nearly all Japanese banks increased sharply, exacerbated by year-end funding pressures. Stress on the Japanese banking system was highlighted by problems related to Daiwa Bank's operations in the United States and the lack of a resolution to the troubled housing loan corporations (jusen). These concerns were manifested in additional premia on yen- and dollar-denominated LIBOR (London Interbank Offered Rate) deposits that Japanese banks had to pay to borrow money. Although the Japan premium subsequently receded, concerns about the health of the Japanese banking system continued to linger through the remainder of the quarter.

TENSIONS AMONG CURRENCIES IN THE EUROPEAN UNION

As the quarter began, the dollar eased against the mark. Among the factors adversely affecting the dollar, tensions among currencies in the European Union (EU) remained most discernible. These strains sporadically escalated as public sector strikes against social-security-reform measures intensified in France, and uncertainty in Italy regarding the future of Prime Minister Dini's government threatened to jeopardize the 1996 budget process. In late October, as these events increasingly drew the attention of market participants, the German mark generally strengthened against other EU currencies. Subsequently the dollar sustained losses against the mark to reach the quarter's low of DM 1.3808. Later, however, the French government demonstrated its commitment to preserve the core social-security-reform measures, and Italy's 1996 budget process advanced. As a result, the mark reversed its earlier trend and weakened against other European currencies. In turn, this weakening trend helped the dollar to recover against the mark.

EXPECTATIONS OF LOWER INTEREST RATES IN EUROPE

As the quarter progressed, expectations that European interest rates would decline, bolstered by evidence of slowing economic growth and subsiding inflationary pressures in major European countries, boosted the dollar to the quarter's high of DM 1.4550 against the mark on December 8. Subsequently central banks in Germany, the United Kingdom, France, and several other European countries lowered their official interest rates 25-50 basis points in December, a development that led market participants to expect further easing.