treasury and federal reserve foreign exchange...

Treasury and Federal ReserveForeign Exchange Operations

This report, presented by Dino Kos, Senior VicePresident, Federal Reserve Bank of New York, andManager, System Open Market Account, describesthe foreign exchange operations of the U.S. Depart-ment of the Treasury and the Federal Reserve Systemfor the period from January through March 2001.Krista Schwarz was primarily responsible for prepar-ing the report.

During the first quarter of 2001, the dollar appreci-ated 7.3 percent against the euro and 10.3 percentagainst the yen in an atmosphere of increased marketuncertainty about the extent and duration of globaleconomic slowing. On a trade-weighted basis, thedollar ended the quarter 7.4 percent stronger againstan index of major currencies. Despite economic datasuggesting a deceleration of activity in the UnitedStates, the dollar’s gains in value over the quarterprimarily reflected global investors’ preference forU.S. assets. The U.S. monetary authorities did notintervene in the foreign exchange markets during thequarter.

FEDERAL OPEN MARKET COMMITTEEEASES U.S. MONETARY POLICY

During the first quarter, the Federal Open MarketCommittee (FOMC) lowered its target federal funds

rate a total of 150 basis points in three separatemoves, bringing the rate from 6.5 percent to 5.0 per-cent. On January 3, the federal funds rate wascut 50 basis points to 6.0 percent. The FOMC citedweakening sales and production, lower consumerconfidence, and tight conditions in some segments offinancial markets. Market participants came to expectfurther monetary easing in response to additional datareleases pointing to slower growth. Intraday pricevolatility in short-dated U.S. Treasury securities wasexacerbated amid increased uncertainty as forecasts

1. Trade-weighted Group of Three currencies, 2001:Q1

Trade-weighted dollar

Trade-weighted yen

Trade-weighted euro

Jan. Feb. Mar.2001

94

97

100

103

106

Index, January 1 = 100

Note. In this chart and those that follow, the data are for business daysexcept as noted.

Sources. Board of Governors of the Federal Reserve System, The FederalReserve Bank of New York, and the Bank of England.

3. U.S. Treasury yields, 2001:Q1

Jan. Feb. Mar.2001

4.4

4.8

5.2

5.6

Percent

Thirty-year Treasury bond

Two-year Treasury note

Source. Bloomberg L.P.

2. Federal funds target rate and yields impliedby the April federal funds futures andJune eurodollar futures contracts, 2001:Q1

Jan. Feb. Mar.2001

4.75

5.25

5.75

6.25

Percent

Federal funds target rate

April federal funds futures contract

June eurodollar futures contract


394

were rapidly revised. Concerns over the ramificationsof the California utility situation for other sectors ofthe U.S. economy added to market expectations foradditional interest rate reductions.

On January 31, the FOMC announced a reductionof 50 basis points in the target federal funds rate to5.5 percent. In line with market expectations forfurther easing, the FOMC indicated that the balanceof risks remained weighted toward economic weak-ness. Market participants cited anticipated easing asa factor contributing to improved investor senti-ment. Over the quarter, the two-year Treasury yielddeclined 92 basis points while the yield on thethirty-year bond was nearly unchanged, bringingthe spread between the two- and thirty-year Treasuryyields to 126 basis points. Rising investor cautionstymied a brief rally in global equity markets as weakcorporate profit forecasts and disappointing earningsprompted steep declines in major indexes. In earlyMarch, the Nasdaq index fell below the 2000 pointlevel for the first time since December 1998, and theS&P 500 and the Nikkei indexes also reached multi-year lows. During the quarter, these three indexes fell25.5, 12.1, and 5.7 percent respectively.

The FOMC reduced the target federal funds rate anadditional 50 basis points at its March 20 meeting,bringing the official rate to 5.0 percent. The centralbanks of Canada, the United Kingdom, Switzerland,Japan, Australia, and New Zealand also loweredofficial rates during the quarter in light of eco-nomic pressure stemming, in part, from global mar-ket developments.

ECONOMIC AND POLITICAL FACTORS AFFECTSENTIMENT TOWARD JAPANESE SECURITIES

On a trade-weighted basis, the yen declined 6.2 per-cent, with some of its sharpest losses occurring

during the second half of the quarter. The yen’sshort-lived midquarter strength against other majorcurrencies was widely attributed to fiscal year-endrepatriation flows and to decisions by foreign assetmanagers to purchase Japanese securities to bringtheir portfolio positions closer to neutral. In the sec-ond half of the quarter, however, market sentimenttoward Japan turned negative as economic and politi-cal prospects became more uncertain. Risk-reversalsin dollar–yen and euro–yen options skewed toward apremium for yen puts across maturities, and netspeculative short yen positions on the InternationalMonetary Market rose to their highest level sinceSeptember 1999. Comments by Japanese officialsthat were interpreted as suggesting tolerance towardyen depreciation contributed to the yen’s weakness atthe end of the quarter. Protection against exchangerate movements became more expensive, with option-implied volatility in euro–yen and dollar–yen con-tracts rising 0.6 and 3.1 percent, respectively, overthe quarter. In March alone, the yen depreciated

4. U.S. and Japanese equity indexes, 2001:Q1

Jan. Feb. Mar.2001

80

90

100

110


Nasdaq

S&P 500

Nikkei


6. One-month euro–yen and dollar–yen optionimplied volatility, 2001:Q1

16

17

18

Percent

Euro–yen

Dollar–yen

11

12

13

Percent

Jan. Feb. Mar.2001

Source. J.P. Morgan Chase & Co.

5. The yen against the dollar and the euro, 2001:Q1

Jan. Feb. Mar.2001

105

110

115

120

125

Yen per dollar or euro

Dollar–yen

Euro–yen


395

2.3 percent against the euro and 7.0 percent againstthe dollar, its weakest level since September 1998.

From the outset of the quarter, speculation over thetype and timing of the Bank of Japan’s action tostimulate the economy contributed to market uncer-tainty. In January, Bank of Japan officials discour-aged expectations of a return to a near-zero interestrate policy. On February 9, the Bank of Japanannounced changes aimed at improving money mar-ket liquidity, including a reduction of 15 basis pointsin the discount rate to 35 basis points, the creationof a standby Lombard-style lending facility, activeoutright Treasury-bill purchases for money marketoperations, and enhancements to bill purchase opera-tions. On February 28, the Bank of Japan lowered theovernight call rate target and the rate on the standbyfacility to 15 and 25 basis points, respectively, citing

slowing exports and production. On March 19, theBank of Japan announced a shift in its operationaltarget, effectively returning to the near-zero interestrate policy for call money. The yield implied by theJune three-month euroyen futures contract declined30 basis points on the quarter, reaching 0.12 percentat the quarter-end.

On February 16, the Japanese Cabinet Officedowngraded its overall assessment of the economy,citing concern over a slowdown in external demand,and on February 22, Standard & Poor’s downgradedJapan’s long-term local and foreign currency sover-eign credit ratings. Persistent rumors of Prime Minis-ter Mori’s impending resignation added to negativemarket sentiment. Through February and earlyMarch, the Topix and Nikkei stock indexes declinedto two- and sixteen-year lows, respectively, lendingfurther support to the Japanese government bond(JGB) market. Yields on two- and ten-year JGBsdeclined to 0.14 and 1.28 percent, respectively, theirlowest levels since June 1999. During the remainderof March, ahead of the Japanese fiscal year-end,equities staged a sharp recovery from midmonth lowswith the Topix and Nikkei indexes gaining 10.0 and9.9 percent, respectively, and JGB yields roseslightly.

THE EURO WEAKENS AGAINST THE DOLLARDESPITE NARROWING INTEREST RATEDIFFERENTIALS

At the outset of the quarter, the euro–dollar exchangerate was near 0.94. Despite a 68-basis-point narrow-ing of the spread between two-year dollar and euroswaps and aggressive monetary policy easing in theUnited States, the euro depreciated 6.3 percent over

7. Bank of Japan overnight call rate target andyield implied by the June euroyen futures contract,2001:Q1

Jan. Feb. Mar.2001

.15

.20

.25

.30

.35

.40

Percent

Euroyen futures contract

Japanese overnightcall rate target

Note. On March 19, the Bank of Japan discontinued targeting the overnightcall rate.


8. Ten-year Japanese government yield andNikkei equity index, 2001:Q1

1.14

1.28

1.42

1.56

Percent

Ten-year Japanese government bonds

Nikkei index

Jan. Feb. Mar.2001

80

90

100

110



9. Two-year U.S.–euro swap differential, 2001:Q1

Jan. Feb. Mar.2001

40

60

80

100

Basis points

U.S. rate minus euro rate


396 Federal Reserve Bulletin June 2001

the quarter. On a trade-weighted basis, the eurodeclined 2.4 percent.

Over the first half of the quarter, prospects for anear-term resumption of U.S. growth continued toshift to a later date, and market participants debatedthe possibility of a more pronounced economic slow-down. The apparent resilience of growth in the euroarea contributed to market expectations that lessmonetary policy easing would be forthcoming in theeuro area relative to the United States. The yieldimplied by the June euribor futures contract declinedonly 3 basis points to 4.50 percent, and the two- toten-year German government yield curve flattened10 basis points to a spread of 31 basis points. Untilmidquarter, the euro–dollar exchange rate was littlechanged.

In March, asset prices began to reflect expectationsof some monetary easing by the European CentralBank (ECB) against the backdrop of a slowing global

growth outlook. The yield implied by the Juneeuribor futures contract declined 15 basis points to4.27 percent, and the two- to ten-year German sover-eign yield curve steepened 19 basis points to a spreadof 57 basis points. A sharp decline in German busi-ness confidence for February, as measured by the Ifo(Information und Forschung) survey, and steep Euro-pean equity market losses contributed to expectationsof slower growth in the euro area. In addition, eco-nomic data revealed stabilizing headline inflation andmoderating money supply growth moving toward theECB’s reference value. In this environment, marketparticipants began to view interest rate cuts by theECB as imminent. Over the month of March, the eurodepreciated 4.9 percent against the dollar.

Many investors expressed surprise at the dollar’scontinued appreciation against the euro, particularlyas interest rate differentials continued to narrow. Thedollar’s gains were supported by perceptions of therelatively greater resilience of the U.S. economy anda preference for U.S. fixed-income assets. Marketreports indicated that U.S investors were scaling backforeign holdings and that foreign investors werereallocating into U.S. debt instruments. ECB dataindicated that there was a 50 billion net investmentoutflow from the euro area in January, the highestmonthly outflow since January 2000. In addition,International Monetary Market data indicated areduction in net long euro positions over the quarter.

TREASURY AND FEDERAL RESERVE FOREIGNEXCHANGE RESERVES

The U.S. monetary authorities did not undertake anyintervention operations this quarter. At the end of thequarter, the current values of the euro and yen reserve

10. One-month dollar–yen and euro–dollar risk reversals,2001:Q1

Dollar–yen risk reversal rate

Jan. Feb. Mar.2001

1

0–

+

1

2

Percent

Euro–dollar risk reversal rate

Dollar callsat premium

Dollar putsat premium

Source. J.P. Morgan Chase & Co.

11. Net speculative long euro positions on International Money Market and spot euro–dollar exchange rate, 2001:Q1

7,500

15,000

22,500

Contracts

Net long euro positions

Dollars per euro

Jan. Feb. Mar.2001

.89

.91

.93

.95

Dollars per euro


Treasury and Federal Reserve Foreign Exchange Operations 397

holdings totaled $14.6 billion for the Federal ReserveSystem and $14.6 billion for the Treasury’s ExchangeStabilization Fund. The U.S. monetary authoritiesinvest all of their foreign currency balances in avariety of instruments that yield market-related ratesof return and have a high degree of liquidity andcredit quality. To the greatest extent possible, theseinvestments are split evenly between the FederalReserve System and the Exchange Stabilization Fund.

A significant portion of the balances is invested ingovernment securities held directly or under repur-

chase agreement. Foreign currency reserves are alsoinvested in deposits at the Bank for InternationalSettlements and in facilities at other official institu-tions. As of March 31, direct holdings of foreigngovernment securities totaled $12.9 billion, splitevenly between the two authorities. Foreign govern-ment securities held under repurchase agreementtotaled $2.8 billion at the end of the quarter and werealso split evenly between the two authorities.

Tables appear on page 399.

398 Federal Reserve Bulletin June 2001

2. Net profits or losses (−) on U.S. Treasuryand Federal Reserve foreign exchange operations,based on historical cost-of-acquisition exchange rates,2001:Q1Millions of dollars

Period and item

FederalReserve

System OpenMarket Account

U.S. TreasuryExchange

StabilizationFund

Valuation profits and losses onoutstanding assets and liabilities,Dec. 31, 2000Euro . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −936.6 −1,153.3Japanese yen . . . . . . . . . . . . . . . . . . . . . . 1,194.7 1,406.9

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258.1 253.6

Realized profits and lossesfrom foreign currency sales,Dec. 31, 2000–Mar. 31, 2001Euro . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .0 .0Japanese yen . . . . . . . . . . . . . . . . . . . . . . .0 .0

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .0 .0

Valuation profits and losses onoutstanding assets and liabilities,Mar. 31, 2001Euro . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −1,408.1 −1,624.6Japanese yen . . . . . . . . . . . . . . . . . . . . . . 459.5 671.6

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . −948.6 −953.0

3. Reciprocal currency arrangements, March 31, 2001Millions of dollars

Institution Amount offacility

Outstanding,Mar. 31, 2001

Reciprocal currencyarrangements

Bank of Canada . . . . . . . . . . . . . . . . . . . . 2,000 .0Bank of Mexico . . . . . . . . . . . . . . . . . . . . 3,000 .0

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 .0

Federal Reserve and U.S. TreasuryExchange Stabilization Fund

currency arrangements

Bank of Mexico . . . . . . . . . . . . . . . . . . . . 3,000 .0

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 .0

1. Foreign currency holdings of U.S. monetary authorities based on current exchange rates, 2001:Q1Millions of dollars

Item Balance,Dec. 31, 2000

Quarterly changes in balances, by source

Balance,Mar. 31, 2001Net purchases

and sales1Effect of

sales 2Investment

income

Currencyvaluation

adjustments 3

Interestaccrual

and other 4

Federal Reserve SystemOpen Market Account

(SOMA)Euro . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,375.9 .0 .0 91.4 −471.6 . . . 6,995.7Japanese yen . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,244.6 .0 .0 5.9 −735.2 . . . 7,515.3

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,620.5 .0 .0 97.3 −1,206.8 . . . 14,511.0

Interest receivables (net) 5 . . . . . . . . . . . . . . . . . . . . 76.5 . . . . . . . . . . . . −.6 75.9Other cash flow from investments 4 . . . . . . . . . . . .0 . . . . . . . . . . . . .0 .0

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,697.0 .0 .0 97.3 −1,206.8 −.6 14,586.9

U.S. Treasury ExchangeStabilization Fund (ESF)

Euro . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,373.1 .0 .0 91.8 −471.4 . . . 6,993.5Japanese yen . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,244.7 .0 .0 5.9 −735.3 . . . 7,515.3

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,617.8 .0 .0 97.7 −1,206.7 . . . 14,508.8

Interest receivables 5 . . . . . . . . . . . . . . . . . . . . . . . . . 61.2 . . . . . . . . . . . . 11.2 72.4Other cash flow from investments 4 . . . . . . . . . . . .0 . . . . . . . . . . . . . . . .0

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,679.0 .0 .0 97.7 −1,206.7 11.2 14,581.2

Note. Figures may not sum to totals because of rounding.1. Purchases and sales for the purpose of this table include foreign cur-

rency sales and purchases related to official activity, swap drawings and repay-ments, and warehousing.

2. This figure is calculated using marked-to-market exchange rates; itrepresents the difference between the sale exchange rate and the most recentrevaluation exchange rate. Realized profits and losses on sales of foreign cur-rencies, computed as the difference between the historical cost-of-acquisitionexchange rate and the sale exchange rate, are reflected in table 2.

3. Foreign currency balances are marked to market monthly at month-endexchange rates.

4. Values are cash flow differences from payments and collection of fundsbetween quarters.

5. Interest receivables for the ESF are revalued at month-end exchange rates.Interest receivables for the Federal Reserve System are carried at average costof acquisition and are not marked to market until interest is paid.

. . . Not applicable.

Treasury and Federal Reserve Foreign Exchange Operations 399

Treasury and Federal Reserve Foreign Exchange Operations

This report, presented by Dino Kos, Senior Vice President, Federal Reserve Bank of New York, and Manager, System Open Market Account, describes the foreign exchange operations of the U.S. Depart-ment of the Treasury and the Federal Reserve System for the period from April 2001 through June 2001. Krista Schwarz was primarily responsible for prepar-ing the report.

During the second quarter of 2001, the dollar appre-ciated 3.3 percent against the euro and depreciated 1.2 percent against the yen. On a trade-weighted basis, the dollar ended the quarter nearly unchanged against the currencies of the United States' major trading partners. Over the quarter, market perceptions that the U.S. economy would emerge from its down-turn sooner than the euro area provided underlying support for the dollar. The U.S. monetary authorities did not intervene in the foreign exchange markets during the quarter.

PROSPECTS FOR AN ECONOMIC TURNAROUND DRIVE U.S. MARKET SENTIMENT

The Federal Open Market Committee (FOMC) low-ered the target federal funds rate a total of 125 basis points, from 5.0 percent to 3.75 percent, during the

second quarter. Market participants debated the extent of the U.S. economic slowing and considered the scope for any future easing in monetary policy. Mar-ket discussion on the outlook for inflation contributed to Treasury yield curve steepening. Over the quarter, the two-year Treasury yield rose 6 basis points while the yield on the ten-year note rose 49 basis points, widening the spread between the two- and ten-year yields 43 basis points, to 117 basis points.

Figure 1. U.S. Treasury yields, 2001:Q2 [Graph displaying data that illustrates the information Discussed in the previous text. Data plotted as two lines: ten-year Treasury note and two-year Treasury note, for April through June 2001. The range of the Y-axis is approximately 3.5 to 6.0 percent. Over the quarter, the two-year Treasury note rose from about 5% to about 5.4% while the ten-year note started at about 4.25% and ended at about 4.25%, widening the spread between the two- and ten-year notes from about .75% to about 1.15%.]

NOTE. In this chart and those that follow, the data are for business days, except as noted.

SOURCE. B l o o m b e r g L . P .

Early in the quarter, the release of stronger-than-expected data for GDP growth in the first quarter boosted optimism for growth prospects for the remainder of the year. Additionally, several announcements of first-quarter earnings contributed to a temporary revival in investor sentiment. Global equity indexes rallied, with the S&P 500, the Topix (Tokyo Stock Exchange Price Index), and the DJ Euro Stoxx indexes gaining as much as 13.1 per-cent, 12.8 percent, and 8.8 percent respectively. How-ever, other U.S. economic data releases, such as the March and April employment reports, suggested con-tinued softening in some sectors of the economy, heightening expectations for further easing of mone-tary policy by the FOMC. Over the quarter, yields implied by the July and September federal funds futures contracts declined 59 and 58 basis points, to 3.75 percent and 3.67 percent respectively.

Figure 2. Federal funds target rate and yields implied by the July and September federal funds futures contracts, 2001:Q2

[Graph displaying data that illustrates the information Discussed in the previous text. Data plotted as three lines: Federal funds target rate, July Federal Funds futures contract, and September federal funds futures contract, for April through June 2001. The range of the Y-axis is approximately 3.25 to 5.25 percent. The Federal funds target rate started at 5% but yields were about 4.25% (September) and 4.36% (July). Federal funds target rate dropped to 4.50% in April, but the two yields dropped to 4% and below. In May the target rate dropped to 4% but the two yields were sliding down to 3.75% and below. They ended the second quarter at 3.75% (July) and 3.67% (September), meaning a drop of around .6% for each for Q2.]


In the second half of the quarter, additional reports of declining corporate profitability and indications of deteriorating growth in other major economies weighed broadly on sentiment. Diminished prospects for economic recovery prompted declines in global equity indexes, which pared gains made earlier in the quarter. On balance, the S&P 500, the Topix, and the DJ Euro Stoxx indexes rose 5.5 percent, 1.9 percent, and 1.0 percent, respectively, over the second quarter.

Figure 3. Global benchmark equity indexes, 2001:Q2 [Graph displaying data that illustrates the information discussed in the previous text. Data plotted as three lines: S&P 500, DJ Euro Stoxx, and Topix, for April through June 2001. The range of the Y-axis is approximately an index of 95 to 115. The three three indexes start at around 99-100. There's a general trend upwards through the middle of the quarter to around 109, with a spike for Topix to about 113 early May and for S&P 500 to about 113 late May. After May they all have a downward trend. At the end of Q2 S&P 500 is at about 106 (for a Q2 increase of 5.5%), Topix is at about 102 (for a Q2 increase of 1.9%) and DJ Euro is at about 101 (for a Q2 increase of 1.0%).]


Directional trends in major currency pairs were largely muted, and the dollar closed the quarter nearly unchanged on a trade-weighted basis. A notable decline in option implied volatility across maturi-ties in the Group of Three currencies suggested lower investor demand for protection against sharp exchange rate movements and a greater level of com-fort with recent trading ranges and directional trends. The dollar traded in a range of $0.87 to $0.91 against the euro and moved between ¥120 to ¥125 for most of the quarter. One-year dollar-yen and euro-dollar

implied volatilities reached their lowest levels in more than a year and ended the quarter 2.5 and 2.3 percentage points lower, at 10.65 percent and 10.9 percent respectively.

Figure 4. Trade-weighted Group of Three currencies, 2001:Q2 [Graph displaying data that illustrates the information discussed in the previous text. Data plotted as three lines: Trade-weighted yen, Trade-weighted dollar, and Trade-weighted euro, for April through June 2001. The range of the Y-axis is approximately an index of 95 to 110. Trade-weighted yen starts at about 99, while Trade-weighted dollar and Trade-weighted euro start at about 100. Dollar and euro stay at about this level the whole quarter while yen has a spike in early June of about 107. Yen ends the quarter at about 102, making it 3 percent higher than it started. Dollar ends the quarter at about 99, making it 1 percent lower than it started. Euro ends the quarter at about 97.5, making it 2.5 lower than it started and depreciated 3.2 percent against the dollar and 4.4 percent against the yen.]

SOURCES. Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, and the Bank of England.

EURO-AREA COUNTRIES SHOW SIGNS OF DECELERATING GROWTH; CAPITAL OUTFLOWS CONTINUE

The euro depreciated 3.2 percent against the dollar and 4.4 percent against the yen. After trading in a relatively narrow range against the dollar during the first half of the quarter, the euro weakened to a new low for the year. Economic data indicating slowing euro-area growth and rising inflation and debate among market participants regarding the objectives of the European Central Bank (ECB) weighed on sentiment toward the single currency. Net cross-border investment outflows and a shift in investor positioning further pressured the euro.

Figure 5. One-year euro-dollar and dollar-yen option implied volatility, 2001:Q2

[Graph displaying data that illustrates the information discussed in the previous text. Data plotted as two lines: Euro-dollar, and Dollar-yen, for April through June 2001. The range of the Y-axis is approximately an index of 9 to 14 percent. Euro-dollar and Dollar-yen both start the quarter at about 13.2%. They both mostly drop throughout the quarter, euro-dollar being about 1% above the dollar-yen, until mid-June when they come together and finish the quarter with euro-dollar at 10.9 percent (2.3% lower than it started) and dollar-yen at 10.65 percent (2.5% lower than it started).]

SOURCE. J.P. Morgan Chase & Co.

According to the ECB, the net outflow of direct and portfolio investment from the euro area totaled €20.8 billion in April, after an outflow of €86 billion in the first quarter of 2001. The largest outflows were by nonresidents, totaling €11.3 billion. The data seemed to corroborate anecdotal market reports that highlighted Japanese disinvestment from the euro area as the currency-adjusted value of these invest-ments deteriorated. Additionally, after the yen's appreciation in May, positioning data from the Inter-national Monetary Market showed that net euro posi-tions by speculative investors turned short for the first time in nine months.

Early in the quarter, euro-area economic data indi-cated that growth was slowing and price pressures were rising. M3 growth and headline inflation—the

ECB's stated monetary policy pillars—remained above their respective reference values. On May 10, the ECB surprised market participants by lowering official interest rates 25 basis points, bringing the two-week marginal refinancing rate to 4.50 percent. Among the factors cited as contributing to the deci-sion was that the ECB identified an upward distortion in data for M3 growth and a diminution of upward risks to price stability.

Later in the quarter, however, economic data for the euro area continued to show signs of rising infla-tion, shifting expectations for another interest rate reduction to a later date. The yield implied by the September 2001 three-month euribor futures contract rose 20 basis points, to 4.25 percent, while the yield implied by the March 2002 contract rose only 11 basis points. Meanwhile, data releases for the euro area showed continued deceleration in economic activity, most notably in Germany, lending a measure

of support to expectations for further easing. Addi-tionally, the ECB and several German research insti-tutes revised their growth projections downward for the euro area.

Although the FOMC eased policy more than the ECB, long-dated interest rate differentials remained in favor of the dollar in the second quarter. After the ECB's May 10 move to ease rates, the spread between the ten-year swap rates for the dollar and the euro reached its widest level for the year at 91 basis points. The euro depreciated 4.6 percent against the dollar in May after the policy change. On balance over the second quarter, short-dated interest rate dif-ferentials moved further in favor of the euro but at a less rapid pace than in the first quarter.

Figure 6. Currency-adjusted price returns on euro-denominated government bond index, 2001:Q2

[Graph displaying data that illustrates the information discussed in the previous text. Data plotted as three lines: returns in Euros, Returns in Dollars, and Returns in Yen, for April through June 2001. The range of the Y-axis is approximately an index of 85 to 105. Dollars and Euros start at about 100 at the beginning of Q2, and yen starts at about 101. Euros stays the steadiest and ends at about 98. Dollars and yen move up and down about 2% or so but with a downwards trend until early June when yen reaches about 89 and dollars reach about 94. At the end of the quarter euros is about 98%, and dollars and yen are around 94%.]

SOURCE. Merrill Lynch.

Figure 7. Dollar-euro swap spreads, 2001:Q1 and Q2 [Graph displaying data that illustrates the information discussed in the previous text. Data plotted as two lines: Ten-year spread and Two-year spread, for January through June 2001. The range of the Y-axis is approximately -20 to 120 basis points. The Ten-year spread starts at about 65 basis points in January and ends at about 90 basis points in the end of June. The Two-year spread starts at about 110 basis points in January and ends at about 50 basis points in the end of June. There are dashed vertical lines indicating interest rate cuts by the FOMC. They are at the beginning of January (followed by a 30 point drop by each) and end of January (followed by a 25 point rise by each), Mid-March (followed by a 40 point rise by each), Mid-April (ten-year spread did not move much, but two-year spread followed with about a 40 point drop), late the first half of May (two-year spread did not move much, but ten-year spread followed with about a 20 point drop), and late June (followed by a rise in each). The end of the first quarter of May there was an interest rate cut by the ECB, after wich both lines rose.]


THE YEN RESPONDS TO BROAD SHIFTS IN LOCAL AND INTERNATIONAL INVESTOR FLOWS

The yen appreciated as much as 6.0 percent and 10.0 percent against the dollar and the euro before depreciating to end the quarter 1.2 percent and 4.6 percent stronger against the dollar and the euro respectively. Investor sentiment toward Japan improved after Japan's ruling party selected a new prime minister in April, and investor position adjust-ments contributed to yen strength in the first half of the quarter. However, signs of further economic deterioration, delays in implementing anticipated reforms, and market perceptions of official U.S. and Japanese tolerance for yen depreciation reintroduced a negative bias toward Japanese assets and contrib-uted to the yen's subsequent decline against the dol-lar and the euro.

Running on a platform of widespread reform, Junichiro Koizumi became Japan's prime minister after Liberal Democratic Party members elected him as their new party leader on April 24. Prime Minister Koizumi's plans for structural reform and fiscal restraint initially boosted investor optimism toward Japanese securities, providing underlying support for the yen. Net purchases of Japanese equities by for-eign investors, who many market participants esti-mated were underweight in Japanese stocks relative to their benchmarks, rose to their highest level since December 1999. Additionally, in mid-May, the euro's weakness and resulting Japanese investor losses reportedly led to a retrenchment of European invest-ments by Japanese investors. The yen's initial appre-ciation sparked a spate of short yen position cover-ing, further accelerating the exchange rate movement. Against this backdrop of position adjustment and capital flows, the yen appreciated sharply in late May,

breaking below the ¥120 and ¥101 levels against the dollar and the euro respectively.

In June, this price action was largely reversed: The yen weakened 4.5 percent against the euro and 4.9 percent against the dollar, as post-election enthu-siasm and initial hopes for specific structural reform plans began to ebb. In addition, market participants interpreted a Japanese newspaper report as suggest-ing that U.S. policymakers would tolerate a weaker yen exchange rate if it resulted from a restructuring of Japan's economy. Japanese economic data and downward revisions of growth forecasts reduced investor expectations for an economic recovery. Japan's trade surplus for May declined markedly, largely attributed to economic deceleration in Japan's major trading partners. According to the Tokyo Stock Exchange, net foreign buying of Japanese equities early in the quarter became net foreign selling in the second half of the quarter. The Topix subindex for the banking sector fell as much as 15 percent, reaching its lowest level since October 1998.

Figure 8. Foreign investor flows for Japanese equities and the Topix equity index, 2001:Q2

[Graph displaying data that illustrates the information discussed in the previous text. Data plotted as a line (Net foreign equity flows in billions of yen) and a bar graph (Topix index in points), for April through June 2001. The range of the Y-axis is approximately 1200 to 1450 points and -450 to 450 billion yen. From the beginning of April to the early second half of April the Net foreign equity flows were outflows at negative amounts of yen, ranging from about negative 225 billion yen to about 0 yen. From then to about the end of May there were inflows at positive yen, starting at 0 and climbing to about 342 billion yen then progressing down to 0. More outflows from the end of may until the end of June. The Net foreign equity flows reaches a maximum low at the beginning of the second half of June at about negative 263 yen. Topix index is about 1380 then 1410 then 1395 then 1425 then 1375 points in April. In May it is about 1375 then 1440 then 1410 then 1340 then 1350 points. In June it is about 1300 then 1225 then 1325 then 1315 then1340.]

SOURCES. Tokyo Stock Exchange and Bloomberg L.P.

Figure 9. The yen against the dollar and the euro, 2001:Q2 [Graph displaying data that illustrates the information discussed in the previous text. Data plotted as two lines , yen per dollar and yen per euro, for April through June 2001. The range of the Y axis is approximately 100 to 130 yen per dollar or euro. April starts with about 127 yen per dollar and about 112 yen per euro. May starts with about 121 yen per dollar and about 108 yen per euro. June starts with about 119 yen per dollar and about101 yen per euro. June ends with about 125 yen per dollar and about 106 yen per euro.]


In an effort to better maintain its target level of ¥5 trillion in current account balances, the Bank of Japan implemented several operational changes in its money market and repurchase agreement transactions during the quarter. Market impressions that economic conditions in Japan were worsening were confirmed by economic data that showed that GDP growth was negative in the first quarter and by the Bank of Japan's downgrade of its assessment of the state of the Japanese economy. This led to market speculation that the Bank of Japan may be preparing to adopt measures to further ease its monetary policy stance, perhaps by raising its target level for financial institu-tions' current account balances. Reflecting a growing certainty among market participants that short-term spot interest rates will remain near zero for some time, yields implied by euro-yen futures contracts across maturities fell, and the yield on the two-year Japanese government bond declined 8 basis points, to 6 basis points.

Figure 10. Yields on short-term Japanese fixed-income securities, 2001:Q2

[Graph displaying data that illustrates the information discussed in the previous text. Data plotted as two lines , September euroyen futures contract, and two-year Japanese government bond, for April through June 2001. The range of the Y axis is approximately 0 to 20 percent. In the beginning of April the Two-year Japanese government bond is about .19% and the September euroyen futures contract is about .125%. In the beginning of May the Two-year Japanese government bond is about .12% and the September euroyen futures contract is about .10%. In the beginning of June the Two-year Japanese government bond is about .07% and the September euroyen futures contract is about .08%. At the end of June the two-year Japanese government bond is about .065% and the September euroyen futures contract is about .09%.]


TREASURY AND FEDERAL RESERVE FOREIGN EXCHANGE OPERATIONS

The U.S. monetary authorities did not undertake any intervention operations this quarter. At the end of the quarter, the current values of the euro and yen reserve holdings totaled $14.5 billion for the Fed-eral Reserve's System Open Market Account and $14.5 billion for the U.S. Treasury's Exchange Stabi-lization Fund. 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. To the greatest extent possible, these investments are split evenly between the Federal Reserve System and the Treasury.

A significant portion of the U.S. monetary authori-ties' foreign exchange reserves is invested in govern-ment securities held outright or under repurchase agreements. During the quarter, the U.S. monetary authorities expanded the pool of euro-denominated repurchase agreement collateral that they will accept. In addition to German sovereign debt, the U.S. mone-tary authorities now accept sovereign debt backed by the full faith and credit of the governments of Belgium, France, Italy, the Netherlands, and Spain.

Foreign currency reserves are also invested in deposits at the Bank for International Settlements and in facilities at other official institutions. As of June 30, direct holdings of foreign government secu-rities totaled $12.9 billion, split evenly between the Federal Reserve's System Open Market Account and the U.S. Treasury's Exchange Stabilization Fund. Foreign government securities held under repur-chase agreement totaled $2.8 billion at the end of the quarter and were also split evenly between the two authorities.

Discontinuation of ''Treasury and Federal Reserve Foreign Exchange Operations" in the Federal Reserve Bulletin

The quarterly report ' 'Treasury and Federal Reserve For-eign Exchange Operations,'' by the Federal Reserve Bank of New York, will not be reprinted in the Federal Reserve Bulletin after the December 2001 issue. Each quarter's report is available soon after the end of the quarter on the web site of the Federal Reserve Bank of New York (www.newyorkfed.org/pihome/news/forex/), which also has the reports back to 1996. The reports for years before 1996 are available in paper copies from the Public Infor-mation Department, Federal Reserve Bank of New York, 33 Liberty Street, New York, NY 10045 (tel. 212-720-5424).

Other reprints will also be eliminated from the Bulletin after December 2001: the monthly report on industrial production and capacity utilization, congressional testi-mony, the FOMC minutes, and the Federal Reserve Bank of New York's annual ' ' Open Market Operations'' report (the text portion of ' 'Open Market Operations'' will be reprinted in the Board's Annual Report rather than in the Bulletin). The documents are widely distributed when originally published, and several sources for historical information are available.

1. Foreign currency holdings of U.S. monetary authorities based on current exchange rates, 2001:Q2 Millions of dollars

NOTE. Figures may not sum to totals because of rounding. Note on Net Purchases and Sales:

Purchases and sales for the purpose of this table include foreign cur-rency sales and purchases related to official activity, swap drawings and repay-ments, and warehousing. Note on Effect of Sales:

This figure is calculated using marked-to-market exchange rates; it represents the difference between the sale exchange rate and the most recent revaluation exchange rate. Realized profits and losses on sales of foreign cur-rencies, computed as the difference between the historical cost-of-acquisition exchange rate and the sale exchange rate, are reflected in table 2.

Note on Currency valuation adjustments: Foreign currency balances are marked to market monthly at month-end

exchange rates.

Note on Interest accrual and other, and Other cash flow from investments:

Values are cash flow differences from payments and collection of funds between quarters.

Note on Inerest Receivables: Interest receivables for the ESF are revalued at month-end exchange rates.

Interest receivables for the Federal Reserve System are carried at average cost of acquisition and are not marked to market until interest is paid.

Item Balance, Mar. 31, 2001 Quarterly changes in balances, by source:

Net purchases and sales

Quarterly changes in balances, by source:

Effect of sales


Investment income


Currency valuation

adjustments

Quarterly changes in balances, by source: Interest accrual

and other

Balance, June 30, 2001

FEDERAL RESERVE SYSTEM OPEN MARKET ACCOUNT

(SOMA): Euro 6,995.7 . 0 . 0 81.9 -257.2

na

6,820.4 SOMA: Japanese yen 7,515.3 . 0 . 0 4.6 48.7

na 7,568.6

SOMA: Total 14,511.0 . 0 . 0 86.5 -208.5 na

14,389.0

SOMA: Interest receivables (net) 75.9

na na na na -7 .6 68.3

SOMA: Other cash flow from investments . 0 na na na na

. 0 . 0

SOMA: Total 14,586.9 .0 .0 86.5 -208.5 -7 .6 14,457.3

U.S . TREASURY EXCHANGE STABILIZATION FUND ( E S F ) :

Euro 6,993.5 . 0 . 0 8 1 . 6 -257.2

na

6,817.9 ESF: Japanese yen 7,515.3 . 0 . 0 4.6 48.7

na 7,568.6

ESF: Total 14,508.8 . 0 . 0 8 6 . 2 -208.5 na

14,386.5

ESF: Interest receivables 72.4 na na na na

- 9 . 7 67.0 ESF: Other cash flow from investments . 0

na na na na . 0 . 0

ESF: Total 14,581.2 .0 .0 86.2 -208.5 -9 .7 14,453.5

2. Net profits or losses ( - ) on U.S. Treasury and Federal Reserve foreign exchange operations, based on historical cost-of-acquisition exchange rates, 2001:Q2 Millions of dollars

Period and item

Federal Reserve

System Open Market Account

U.S. Treasury Exchange

Stabilization Fund

Valuation profits and losses on outstanding assets and liabilities, Mar. 31, 2001 Euro -1,408.1 -1,624.6 Japanese yen 459.5 671.6

Total -948.6 -953.0

Realized profits and losses from foreign currency sales, Mar. 31, 2001-June 30, 2001 Euro . 0 . 0

Japanese yen . 0 . 0

Total .0 .0

Valuation profits and losses on outstanding assets and liabilities, June 30, 2001 Euro -1,665.4 -1,881.8 Japanese yen 508.2 720.4

Total -1,157.2 -1,161.4

3. Reciprocal currency arrangements, June 30, 2001 Millions of dollars

Reciprocal currency arrangements.

Institution Amount of facility

Outstanding, June 30, 2001

Bank of Canada 2,000 . 0

Bank of Mexico 3,000 . 0

Total 5,000 .0

Federal Reserve and U.S. Treasury Exchange Stabilization Fund currency arrangements.

Institution Amount of facility

Outstanding June 30, 2001

Bank of Mexico 3,000 .0

Total 3,000 .0

treasury and federal reserve foreign exchange...

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