Foreign exchange operations of the Treasury and the Federal Reserve: February - April 1994

Federal Reserve Bank of New York - Quarterly Review, Spring, 1994

During the February-April period, the dollar declined 4.6 percent against the German mark, 6.5 percent against the Japanese yen, and 3.6 percent on a trade-weighted basis.(1) On the last business day of the period, April 29, the Federal Reserve Bank of New York's Foreign Exchange Desk entered the market to purchase $500 million against the German mark and $200 million against the yen for the U.S. monetary authorities. Contemporaneously, Treasury Secretary Bentsen issued a statement confirming the intervention. In other operations, the Desk liquidated the non-yen and non-mark reserves of the Federal Reserve System and the U.S. Treasury Department's Exchange Stabilization Fund (ESF). Following the assassination of the leading Mexican presidential candidate, U.S. monetary authorities provided a $6 billion temporary swap facility to Mexico. This was superseded on April 26, when the monetary authorities of the United States, Canada, and Mexico announced the creation of the North American Financial Group and the establishment of a trilateral foreign exchange swap facility.

The dollar rises briefly in early February

As the period opened, many market participants had positioned themselves for an extended dollar rally. This anticipated appreciation of the dollar rested in part on the expectation that interest rate differentials would start to move more rapidly in the dollar's favor. Dealers believed that with the U.S. economy strengthening, the Federal Reserve would eventually tighten monetary conditions in the United States, perhaps by the end of the first quarter. Dealers also expected the Bundesbank to lower short-term German interest rates quickly, allowing rates in other parts of Europe to fall as well. Against this backdrop, market participants entered the period holding substantial long-dollar positions against the mark and the yen, and also holding large positions in European government bonds. On February 4, Chairman Greenspan announced the decision of the Federal Open Market Committee (FOMC) to increase pressure on bank reserves, a move that resulted in an increase in the federal funds rate from 3.0 to 3.25 percent. The dollar spiked higher in the days immediately following the tightening, reaching period highs of DM 1.7675 and 109.65[yen] before starting to drift lower (Charts 1 and 2).

The dollar declines first against the yen and then the mark

As the February 11 summit meeting between President Clinton and Japanese Prime Minister Hosokawa approached, market participants increasingly expected the two leaders to announce a compromise resolution of the trade issues under discussion between the two countries in bilateral "framework" talks. Correspondingly, expectations grew that the dollar would start to appreciate once the meeting was over, and market participants began to build up significant long-dollar positions. The dollar closed at 108.13[yen] on Thursday, February 10. Reflecting this positive sentiment toward the dollar, the premium on dollar put options over equally out-of-the-money dollar call options diminished a few days before the meeting. Thus, when President Clinton and Prime Minister Hosokawa announced late in the afternoon on Friday, February 11, that they had failed to reach an agreement and were suspending the framework talks, surprised market participants began to unwind their long-dollar positions. The dollar began to decline in late New York trading and continued to move lower through Asian, European, and early New York dealings on Monday, February 14. The dollar's price adjustment against the yen culminated at about midday, when the dollar dropped sharply to an intraday low of 01.10[yen]. The dollar recovered by the end of the day, however, and traded above 103[yen] for the balance of the month.

As the Bundesbank's February 17 council meeting approached, market participants anticipated that the German central bank would act to lower interest rates for the first time since early December 1993. While the Bundesbank did reduce its discount rate by 50 basis points to 5.25 percent, it disappointed these expectations by leaving its key money market rate, the securities repurchase rate, unchanged. The dollar-mark exchange rate began to trade lower in subsequent days, but sharp sell-offs in U.S. and European bond markets generally dominated market attention during late February.

In early March, the dollar traded above the 105[yen] level, gaining support from signs that Japan was considering private and public initiatives to address its trade surplus. Market participants also appeared to take comfort in the fact that the Clinton Administration's decision to revive "Super 301" trade sanction powers would not result--at least in the short term--in new trade sanctions. However, in mid-March attention increasingly focused on reports that substantial foreign flows of funds into Japanese equity and bond markets were leading to further strength in the yen.

Against the mark, a slower than expected narrowing of short-term interest rate differentials weighed on the dollar during much of March. A surge in German M3 money supply growth, coupled with growing frustration over the Bundesbank's cautious step-by-step reduction of its securities repurchase rate, spurred market participants to reassess their expectation of sharply lower German interest rates Chart 3). These developments also encouraged the view that further rate reductions by the Bundesbank would be calibrated to the Fed's rate increases to minimize the impact on the dollar-mark exchange rate. In this environment, the second 25 basis point rate increase in the federal funds rate resulting from the FOMC's decision, announced after its March 22 meeting, had little impact on the dollar.