Treasury and Federal Reserve Foreign Exchange Operations This report, presented by Dino Kos, Executive Vice growth differentials between the United States and President, Federal Reserve Bank of New York, and the euro area prompted investors to expand their long Manager, System Open Market Account, describes euro positions. The euro's initial appreciation coin- the foreign exchange operations of the U.S. Depart- cided with reports of shorter-term investors having ment of the Treasury and the Federal Reserve System established long positions in the euro. According to for the period from July 2001 through September data from the Commodity Futures Trading Commis- 2001. Evangeline Sophia Drossos was primarily sion (CFTC), net noncommercial long euro positions responsible for preparing the report. on the International Money Market futures exchange rose steadily over the quarter and on August 28 During the third quarter, the dollar depreciated reached their highest levels since the inception of the 7.3 percent against the euro and 4.1 percent against euro. However, market participants suggested that the yen. On a trade-weighted basis, the dollar ended these net long euro positions may have limited the the quarter 2.6 percent lower. Shifting expectations euro's gains somewhat later in the quarter, as inves- about the pace of the U.S. economic recovery influ- tors were reluctant to extend positions further. enced changes in the exchange value of the dollar. The dollar also depreciated against the yen, which Economic data released even before the terrorist strengthened against a wide range of currencies. attacks on September 11 suggested that the U.S. eco- Investors bought yen to cover short positions amid nomic slowdown would likely be more protracted expectations that funds from Japanese accounts than previously expected, which generally weighed would be repatriated from overseas investments on the dollar. The attacks heightened pre-existing ahead of the Japanese fiscal-half-year-end. CFTC concerns about the weakness of the U.S. economy data indicated that noncommercial accounts reported and lent further momentum to the general trends that net short yen positions against the dollar through the prevailed earlier in the quarter. The U.S. monetary end of July, but these positions were reversed in authorities did not intervene in the foreign exchange August. In early September, the number of net long markets during this quarter. After the terrorist attacks, yen positions reached its highest level in almost two the Federal Reserve established thirty-day reciprocal years. swap arrangements with the European Central Bank (ECB) and the Bank of England and temporarily augmented its existing swap facility with the Bank of Figure 1. Trade-weighted Group of Three currencies, 2001:Q3 [graph plots three lines: Euro, Yen, and Dollar from Canada. The ECB drew on the swap facility on three BybeginningJuly the through beginning of September.July. of August All thethree Yen start and at Dollar 100 in are the occasions. 100,Augustdown and to the aboutthe Dollar Euro 99 andisis aboutdown the Euro 104.to about isEarly up 97, to September aboutthe Yen 103. is the aroundLate EuroSeptemberdollar about climbed 11104. the to on aboutdollar September 98, was but about 17then the 97, started dollar yen aboutdropping. was down102, On to aboutThe end 101.5,95.5, of quarterthe and yen euro 3about ended about 102.5, with 104.] dollarthe euro at about 105.97, yen DOLLAR DEPRECIATES THROUGH EARLY SEPTEMBER AMID INCREASED UNCERTAINTY OVER THE PROSPECTS FOR US. ECONOMIC RECOVERY. After reaching new multiyear highs on a trade- weighted basis early in the quarter, the exchange value of the dollar declined amid increased expecta- tions for a more protracted economic slowdown in the United States and a broad retrenchment from risk positions. The euro appreciated against the dollar NOTE. In this chart and those that follow, the data are for business days early in the quarter, rising as high as $0.9182 on except as noted. SOURCES. Board of Governors of the Federal Reserve System, the Federal August 21, as shifting expectations for relative Reserve Bank of New York, and the Bank of England. Figure: 2. Dollar-euro swap differentials, 2001:Q3 Figure: 3. Group of Three government yield curves, 2001:Q3 fromeuro[graph rate,July plotting andthrough two-year two September. lines: dollar ten-year rateThe lessdollarTen-year two-year rate begins less euro ten-year quarter rate U.S.Japanesegraph Treasury plotting government yield,three lines:and bond Ten-year ten-year yield, ten-year minusminus two-yeartwo-year minus two-year andThroughout3 at 40about basis 30 Augustpoints, basis points, thetwo ten-year year two-year between varies at about between 73.15 andabout -5 65 115,JapaneseGerman and bund Germanstarts yield at aboutat fromabout 125 July 90. basis throughThey points, stay september. fairly U.S. atflat about until ten-yearpointsbasis points. and is theabout September two-year 20 and about11the the two-year -10. ten yearOn about September is at -20.about The 17 40 the basis aboutSeptemberearly september,130, and11 German Japanese when isGerman isabout about 100and 135. basisU.S. On start points,September to rise.U.S. 17, Onis two-yearten-year ends at about the quarter-35.] at about 10 basis points, the andAtGerman the Japan end is andatof aboutthe Germany quarter 125, JapanaboutU.S. is 130about about basis 130, 175 points.] and basis US points, about 170. SOURCE. Bloomberg L.P. SOURCE. Bloomberg L.P. the Reserve Bank of Australia each lowered their U.S. economic data reported early in the quarter policy rates 25 basis points. The Bank of Canada showed weakness in both the nonmanufacturing and lowered its policy rate 50 basis points. Implied yields manufacturing sectors, as well as an increase in on global interest rate futures contracts fell in the rate of unemployment, and suggested that the response to the policy rate cuts by central banks and U.S. economic slowdown could be more prolonged. the heightened expectations of additional easing. Among these data reports were the larger-than- Over this period, interest rate differentials between expected declines in the U.S. nonfarm payroll data for the United States and the euro area narrowed. The June and August. Regional economic surveys, such sharpest declines in U.S.-euro area swap spreads as the Chicago Purchasing Managers Index released occurred in the short end of the curve, with the in July and the Philadelphia Business Outlook Survey two-year U.S. swap rate falling below the two-year released in August, also pointed to ongoing contrac- euro-area swap rate for the first time since the incep- tion in manufacturing activity. The August 8 release tion of the euro. of the Federal Reserve's Beige Book was interpreted by many as suggesting that weakness in the manu- Increased expectations for slowing global growth facturing sector had spilled over into the broader prompted investors to pull back from higher-risk economy. Indications of a nascent stabilization in the assets. Global equity indexes and prices on corporate U.S. manufacturing sector, represented by modest debt declined broadly amid increasing pessimism increases reported in the National Association of about corporate profitability worldwide. These fac- Purchasing Managers surveys for July and August, tors, as well as the rate cuts by central banks, contrib- were overshadowed by ongoing concerns about U.S. uted to declines in short-dated sovereign debt yields corporate profitability as analysts continued to lower and to the steepening of sovereign yield curves as their earnings forecasts. Concerns about the U.S. economic outlook were Figure: 4. Global benchmark equity indexes, 2001:Q3 EuroGraph Stoxx comparing from July three through lines: S&P September. 500, Topix, They and all startDJ mirrored in other economies as euro-area and Japa- Late96at about late August July, 100, TopixS&P and all500 about trend is at92, down. about DJ Euro S&P93, Topix Stoxx 500 hits about about about 88, 94. OnaboutDJ EuroSeptember 88, Stoxx Topix 17about about S&P 85. 82, 500 On DJ is September Euroabout Stoxx 84, Topix11, about S&P about 70. 500 78, is nese economic data indicated further deterioration. Stoxxwithand DJ S&P about Euro 500 71.]Stoxx at about about 84, 69. Topix They about end out80 andthe quarterDJ Euro In the euro-area countries, data showed continued declines in the manufacturing sector, particularly in Germany where factory orders fell sharply in July. Data released in August indicated the slowing pace of economic activity, as second-quarter data for German GDP were flat and showed the lowest year-on-year growth rate since 1998. In Japan, economic growth was negative in the second quarter as consumer spending and business investment remained stagnant. In this environment, many central banks eased mone- tary policy; from the beginning of the quarter through early September, the Federal Reserve, the ECB, and SOURCE. Bloomberg L.P. Figure 5. Volatility implied by one-month currency option prices, 1998-2001:Q3 [two graphs, one plotting Dollar-yen and Euro-dollar from 1998 to the third quarter of 2001. the second graph plots Dollar-yen[First graph. toand Beginning about Euro-dollar 12% of and 1998 for Euro-dollar the Dollar-yen three months to startsabout of at 8% 2001 about by Quarter mid 13%, 1998. Euro-dollar 3: JulyDollar-yen through about then September.] 10%. jumps They to bothabout trend 19% down,and varies hithasbetween about a spike that10% to and aboutmid 15% 1999. 28% until Dollar-yenin thethe fourthfourth spikes quarterquarter. to of aboutThey 1998, 23%drop euro-dollar into theabout fourth 16%jumps quarter and to 18%about of 1999,respectively 15% butin the both fourthby are early atquarter. about1999. 10%Dollar-yenThey near both 8-12%euro-dollarthe end in of mid the rises year.2001, to aboutThey and end both17% at riseand about todollar-yen about10-12%.] 15% drops in the to aboutsecond 17%.