Treasury and Federal Reserve foreign operations - November 1993 - January 1994

Federal Reserve Bulletin,  April, 1994  by Peter R. Fisher,  Nicholas Pifer

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This quarterly report describes Treasury and System foreign exchange operations for the period from November through January 1994. It was presented by Peter R. Fisher, Senior Vice President and Manager for Operations for the Federal Reserve Bank of New York. Nicholas Pifer was primarily responsible for preparation of the report. (1)

The dollar appreciated modestly against most major currencies during the November-January period. It rose 2.9 percent against the German mark, 0.1 percent against the Japanese yen, and 0.5 percent on a trade-weighted basis.(2) The U.S. monetary authorities did not undertake any intervention operations during the period.

THE DOLLAR ENDS THE PERIOD VIRTUALLY UNCHANGED AGAINST THE YEN

After opening at 108.64 yen on November 1, the dollar rose against the yen in thin year-end markets, reaching a high of 113.55 yen before coming down to end the period unchanged. Initially, the dollar rose as market participants turned their attention to Japan's lingering recession and to the prospect of interest rate differentials moving in favor of the dollar. This shift in focus was prompted by continued weakness in Japanese money supply growth, employment, industrial production, and retail sales. Moreover, Japanese equity prices dropped sharply in November--with the Nikkei stock index failing nearly 17 percent over the course of the month-- and remained volatile throughout December. Growing pessimism over the economic outlook for Japan, as well as the uncertain prospects for the Hosokawa government' s long-awaited fiscal stimulus package, helped fuel expectations of an additional cut in the Bank of Japan' s Official Discount Rate (ODR).

Over the course of December, trading activity in the dollar-yen exchange market started to ebb as first corporate and then interbank participants pulled back from the market ahead of the year-end holidays. Japanese exporters, who regularly sell dollars to the market to hedge their foreign currency receivables, were notably absent toward the end of the month. In this environment, market conditions were increasingly characterized by the dominance of technically oriented traders who bought up the U.S. currency in anticipation of further dollar gains, and the dollar rose gradually through December from a low of 107.37 yen to a high of 112.05 yen.

In late December, Treasury Secretary Bentsen was asked whether he saw a need to intervene in the foreign exchange market to stem the yen's decline. He responded that he did not think intervention would be necessary but rather thought that the foreign exchange market would focus on Japan's substantial trade surplus when determining the relative value of the dollar and the yen. Secretary Bentsen expressed concern that Japan was not meeting its commitment to achieve domestic demand-led growth and a significant reduction in its external surplus. He expanded on this view in early January when he said that the proper way for Japan to address its economic imbalances was through a combination of effective fiscal stimulus and market-opening measures, not through a depreciation of the yen.

The dollar reached its period high of 113.55 yen on January 5 but soon drifted lower when expected movements in interest rates failed to materialize. Market participants turned their attention to the shifting fortunes of Japanese political reform and to bilateral trade talks with the United States, but they were unable to develop a lasting view on how the success or failure of these two initiatives would affect exchange rates. Reflecting the market's uncertainty about the near-term direction of the dollar against the yen, the implied one-month option volatility for the dollar-yen exchange rate spiked higher in the second half of January. At the same time, foreign investors purchased the equivalent of $10.5 billion in Japanese equities during January; these flows contributed to a sharp rebound in Japanese stock prices and helped support the yen.

The upper house of the Japanese Diet passed Prime Minister Hosokawa's political reform bill on January 29, permitting the government to turn its attention to other policy issues. As the period came to a close, U.S.-Japanese trade talks were continuing and the Japanese government was reportedly at work on a record stimulus package for the economy. Reflecting the positive implications of such a package for Japanese domestic demand growth, the Nikkei surged nearly 8 percent on the last day of the period, and expectations of additional interest rate cuts in Japan receded even further. These factors helped strengthen the yen, and the dollar closed at 108.65 yen on January 31.

DOLLAR APPRECIATES MODESTLY AGAINST THE MARK

During November and most of December, the dollar was relatively stable against the German mark, trading in a narrow range around the DM1.70 level. Market sentiment toward the dollar was generally positive, however, with dealers taking note of the increasingly divergent paths of the U.S. and German economies. In this environment, market participants began to anticipate a fairly rapid convergence of short-term German and U.S. interest rates. The Bundesbank, which had surprised the foreign exchange market in late October, when it cut its discount and Lombard rates 50 basis points, trimmed its key money market repurchase rate from 6.40 percent at the start of the period to 6.25 percent on December 1. At its December 2 council meeting, the Bundesbank announced a prefixed rate of 6.0 percent for the next five weekly auctions of fourteen-day repurchase agreements. Market participants generally interpreted this move as an effort to nudge short-term interest rates lower while also dampening speculation of further monetary easing.