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 expectations 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 inception 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 monetary 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 inof mid the rises year.2001, to aboutThey and end both17% at riseand about todollar-yen about10-12%.] 15% drops in the to aboutsecond 17%. quarter They of both2000. start During 2001 the at aroundfourth quarter 14%, slide of 2000, to about

dollar-yen[second graph. is still In aroundthe beginning 9.5% and of JulyEuro-dollar 2001 the rises dollar-yen to about is 12%. about During 9.5% andthe firsteuro-dollar quarter aboutof August 10%. they Mid-july lower to SeptemberDollar-yenthe dollar-yen 11and Dollar-yenat 12.5% about for8.5%, isEuro-dollar. about euro-dollar 13.5% Early toand about Septembereuro-dollar 10.5%. dollar-yen aboutThey 14%.rise isto There'sabout peak in10.5%, a the jump middle euro-dollar down of to August about about 12%at 11%. 12% for Onfor each Euro-yenthen back aboutup to 14.5%11.5%.] for each mid-september. They both slide down, dollar-yen ending at about 10.75% and

SOURCE. J.P. Morgan Chase & Co.

investors shifted from nongovernment, fixed-income the relatively stable behavior of spot currency rates. securities and equities into safer, more liquid assets. At the same time, market participants continued to Developments in Latin America may also have con- protect against the risk of dollar depreciation as one- tributed to heightened risk aversion early in the quar- month risk reversals showed a preference for dollar ter as investors expressed ongoing concern about the puts against the euro and the yen. ability of Argentina to meet its debt-servicing obli- Expectations for near-term interest rate cuts gations. The Emerging Markets Bond Index Plus increased after September 11, as market participants (EMBI+) sovereign spread over comparable U.S. anticipated that the short-term economic effect of the Treasury securities, which had already widened con- attacks on the U.S. economy would generate sizable siderably earlier in the year, spiked higher in July.

Figure 6. U.S. and euro-area policy rates and implied yields on interest rate futures contracts, 2001:Q3 RISK AVERSION HEIGHTENS FURTHER AFTER target[graph rate, plotting December four lines: 2001 ECB Euribor two-week futures minimum contract impliedbid rate, yield, Federal and Funds untilweekDecember September minimum 2001 bideurodollar17. ratethen was dropped futures 4.5% to Julycontract 3.75%. through implied The August, Federal yield. droppedfunds The ECBtarget to 4.25%two rate SEPTEMBER 11 TERRORIST ATTACKS. The17started then Euribor at dropped 3.75% futures thoughto 3%. contract mid-August, implied yieldthen droppedand eurodollar to 3.5% futures until September contract aboutendimplied of 3.8%, July yield and eurodollar both eurodollar start aboutat aboutdrops 3.45%. 4.2%.to about September Euribor 3.6%. drops End11 Euribor ofto Augustabout is 4%about Euribor by 3.75%, the is eurodollaris about 2.75%. atis aboutabout They 3.1%.2.5%.] end September the quarter 17with Euribor Euribor is aboutat about 3.7%, 3.45% eurodollar and The September 11 terrorist attacks heightened concern about the risks to the U.S. economy, prompting further reductions in risk positions. Against this back- drop, foreign exchange trading volumes declined, as investors were reluctant to establish new positions. Nevertheless, trading in the currency markets appeared orderly but subdued, as many New York dealers moved their activities to local contingency sites and overseas offices in the days immediately following the attacks. In addition, implied volatility on Group of Three currency options spiked after the

attacks but within days quickly declined, reflecting SOURCE. Bloomberg L.P. Figure 7. The dollar against the euro and the yen, 2001:Q3 look. Increased demand among global investors for aboutJuly[graph through 124, comparing dollars September. yenper europer July dollar about starts and .850. with dollars Early yen per perAugust eurodollar yenfrom at the relative safety and liquidity of shorter-dated U.S. aboutLateper dollar August .913. is Early stillyen aboutper September dollar 124, is dollars thereabout is per119, a jumpeuro dollars aboutin yen per .875. per euro Septemberdollar to about 11 yen 121 per and dollar dollars is aboutper euro 120, to dollarsabout .860. per euro Treasury securities helped the dollar partially retrace perdollarsabout dollar .915. per about euroOn September about120 and .925. dollars 17 They yen per endper euro dollarthe aboutquarter is about .910.] with 118, yen earlier declines. The yen initially continued to appre- ciate against other major currencies, ahead of the Japanese fiscal-half-year-end, reaching a high of 116.38 yen per dollar on September 20. The exchange rate closed the quarter at 119.56 yen per dollar, however, after intervention activity by the Japanese monetary authorities late in the quarter aimed at weakening the yen. Japanese monetary authorities publicly con- firmed sales of yen against dollars on September 17 and additional sales of yen on six subsequent occasions through the end of the quarter. SOURCE. Bloomberg L.P. After the September 11 attack, the shift out of higher-yielding markets into perceived safe-haven disruptions in business activity and sharp declines assets pressured the Australian and the New Zealand in consumer confidence. In response to the increased dollars, which depreciated broadly, while the Swiss uncertainty generated by the attacks, many central franc strengthened against other major currencies. An banks lowered their policy rates. On the morning of additional factor that boosted demand for Swiss September 17, before U.S. equity markets resumed francs was position-covering, in anticipation of Swiss trading after four days of closure, the Federal Open franc appreciation, by investors who had borrowed Market Committee lowered the federal funds target the currency to fund positions in higher-yielding rate 50 basis points. Later that day, the Bank of assets. Investors' broad-based reductions in risk posi- Canada, the ECB, and the Swiss National Bank also tions also prompted sharp declines in emerging- cut rates 50 basis points. The next day, the Bank of market and noninvestment-grade corporate debt. The Japan lowered its discount rate 15 basis points and EMBI+ sovereign spread over comparable U.S. Trea- announced an increase in its target for current account sury securities reached its widest level in almost two bank reserves, and the Bank of England lowered its years, and U.S. high-risk corporate yield spreads repurchase agreement rate 25 basis points. reached their highest levels since 1991. In contrast to the sharp price action in some other asset markets, the dollar traded within a relatively narrow range from September 11 to the end of the TEMPORARY SWAP LINES ESTABLISHED WITH quarter. The dollar was little changed on balance OTHER CENTRAL BANKS. against the euro after the attacks, despite the increased uncertainty about the U.S. economic out- To facilitate the functioning of financial markets and provide liquidity in U.S. dollars, the Federal Reserve

Figure 8. U.S. Treasury coupon yields and federal funds target rate, 2001:Q3 Figure 9. Foreign currency per U.S. dollar, 2001:Q3 [graph comparing federal funds target rate, two year note, 3.8%September.ten year and note, stayed The and federalthere thirty until fundsyear it bond wastarget droppedfrom rate Julystarted to throughabout at about 3.5% appreciation,Canadian[graph comparing dollar, anything and three Swiss under currencies franc. 100 isAnything per U.S. dollar: dollar over Australian depreciation. 100 is U.S. dollar, dollar Ten3.0%.mid yearAugust. Beginning note On about 17th of July,5.3%, of September two and year thirty note it yearwas was bonddropped about about 4.2%,to about5.7%. EndisThey about of all august 100,begin Canadian ,July Australian at about dollar dollar 100. about isBy about 102, the end and95, ofSwissCanadian July francAustralian dollar about about dollar95. 102, yearBeginning about of5.0%, August thirty two year year bond note about was 5.6%.about 3.8%,September ten September98,and CanadianSwiss franc17, dollar Australian about about 93. Dollaron103, September and is aboutSwiss 11 102,franc Australian Canadian about 92. dollar dollar On is about about 104, notethirty11 two was year year about bond note 3.0%, about was aboutten 5.4%. year 3.5%, On note September ten about year 4.5%, note 17, twoaboutthirty year 4.9%,year and CanadianSwiss franc dollar about about 90. They104, andend Swissthe quarter franc with about Australian 91.] dollar aboutbond about5.4%.]2.9%, 5.3%. ten year They note end about the quarter4.6%, and with thirty two year bondnote at

SOURCE. Bloomberg L.P. SOURCE. Bloomberg L.P. Figure 10. Emerging-market and U.S. high-yield spreads over U.S. Treasuries, 2001:Q3 Box: Discontinuation of''Treasury and Federal ofhigh-yield[graph July, comparing EMBI+ spread is from EMBI+about July 760, spread through Merrill and September. LynchMerrill about Lynch Beginning 730. Reserve Foreign Exchange Operations" MerrillaboutBeginning 720. Lynch ofOn August aboutSeptember 740. EMBI+ 11, isEMBI+ about was960, about Merrill 900 Lynch and 1000LynchOn September and about Merrill 855. 17, Lynch TheEMBI+ quarter at aboutwas ends about 920.] with 980 EMBI+ and Merrill at about 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-

SOURCES. J.P. Morgan Chase & Co., Merrill Lynch & Co. 5424).

Other reprints will also be eliminated from the Bulletin approved the establishment of temporary reciprocal after December 2001: the monthly report on industrial swap arrangements with the ECB and the Bank of production and capacity utilization, congressional testi- England on September 12 and September 14 respec- mony, the FOMC minutes, and the Federal Reserve Bank tively. Additionally, on September 13, the Federal of New York's annual ''Domestic Open Market Opera- Reserve and the Bank of Canada agreed to a tempo- tions'' report (the text portion of '' Open Market Opera- rary augmentation of the swap facility already in tions'' will be reprinted in the Board's Annual Report place. Under the terms of these agreements, the ECB, rather than in the Bulletin). The documents are widely the Bank of England, and the Bank of Canada would distributed when originally published, and several be able to draw up to $50 billion, $30 billion, and sources for historical information are available. [end of box.] $10 billion, respectively, in exchange for local currency. These arrangements allowed the central banks to provide dollar proceeds of the swaps to be tempo- tion Fund. The U.S. monetary authorities invest their rarily lent to local banks to facilitate the settlement foreign currency balances in a variety of instruments of their dollar transactions. The temporary swap that yield market-related rates of return and have a arrangements with the ECB and the Bank of England, high degree of liquidity and credit quality. To the as well as the augmentation with the Bank of Canada, greatest extent possible, these investments are expired after thirty days. split evenly between the Federal Reserve and the The ECB drew on its swap line on September 12, Treasury. 13, and 14. The net amount drawn totaled $5.4 billion A significant portion of the U.S. monetary authori- on September 12, $14.1 billion on September 13, and ties' foreign exchange reserves is invested in Euro- $3.9 billion on September 14. As of September 17, pean and Japanese government securities held the net amount outstanding fell to zero, and there was outright or under repurchase agreement. Under euro- no further swap activity through the end of the quar- denominated repurchase agreements, the U.S. mone- ter. The Bank of England and the Bank of Canada did tary authorities accept sovereign debt backed by the not draw on their respective swap lines during the full faith and credit of the following governments: quarter. Germany, Belgium, France, Italy, the Netherlands, and Spain. Foreign currency reserves are also invested in deposits at the Bank for International TREASURY AND FEDERAL RESERVE FOREIGN Settlements and in facilities at other official institu- EXCHANGE RESERVES. tions. As of September 28, direct holdings of foreign The U.S. monetary authorities did not undertake any government securities totaled $13.6 billion, split intervention operations during the quarter. At the end evenly between the Federal Reserve and the Trea- of the quarter, the current values of the euro and sury. Foreign government securities held under repur- yen reserve holdings totaled $15.4 billion for the chase agreement totaled $2.8 billion at the end of the Federal Reserve's System Open Market Account and quarter and were also split evenly between the two $15.4 billion for the Treasury's Exchange Stabiliza- authorities. 1. Foreign currency holdings of U.S. monetary authorities based on current exchange rates, 2001:Q3 Millions of dollars

QuarterlyQuarterly changes in balances, changes by source: in balances, by source: Quarterly changes in balances, by source: Balance, Balance, Item Quarterly changes in balances, by source:Interes t June 29, 2001 Effect of Interest RevaluatioQuarterly nchanges in balances, Septby . source:28, 200 1Ne t purchases accrual and sales sales collected and other

FEDERAL RESERVE SYSTEM OPEN MARKET ACCOUNT (SOMA): Euro 6,792.0 .0 .0 87.6 501.0 .0 7,380.6 7,570.2 .0 SOMA: .0 .6 349.2 Japanes.0 e yen 7,920.0 14,362.2 .0 SOMA: .0 88.na2 na 850.2 .0 Total15,300. 6 na 67.1 SOMA: Interest4. receivable9 s -6.6 65.4

14,429.3 .0 SOMA: .0 88.2 855.1 -6.6 Total 15,366.0 na

U.S. TREASURY EXCHANGE STABILIZATION FUND (ESF): Euro 6,787.0 .0 .0 86.3 500.6 7,373.9 na 7,570.3 .0 ESF: .0 .6 349.2 Japanese yen 7,920.1 na 14,357.3 .0 ESF: .0 86.na9 na 849.8 Total15,294. 0 na 66.4 ESF: 4.9 -5.Interes9 t 65.4 receivables

14,423.7 .0 ESF: .0 86.9 854.7 -5.9 Total 15,359.4 Note on RevaluationNote on Interestand Interest Collected: Receivables: NOTE. Balances are now stated at amortized cost. Beginning balances have Current value change in foreign currency from interest collected on been restated to conform with the new presentation. Figures may not sum to matured investments. totals because of rounding. Foreign currency and interest receivables are marked to market daily at Note on Net purchases and Sales: prevailing rates. Purchases and sales for the purpose of this table include foreign currency sales and purchases related to official activity, swap drawings and repayments, 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.

Table 2. Net profits or losses (-) on U.S. Treasury Table 3. Reciprocal currency arrangements, September 28, 2001 and Federal Reserve foreign exchange operations, Millions of dollars based on historical cost-of-acquisition exchange rates, Amount of Outstanding, Reciprocal 2001:Q3 Institution currency facility Sept. 28, 2001 arrangements Millions of dollars

Federal U.S. Treasury Reserve Exchange Period and item: System Open Stabilization Bank of Canada 10,000(see note 1) .0 Market Account Fund Bank of Mexico 3,000 .0 European Central Bank 50,000 (see note 2) .0 Valuation profits and losses on Bank of England 30,000 (see note 3) .0 outstanding assets and liabilities, June 29, 2001 Total 93,000 Institution.0 Euro -1,665.4 -1,881.8 Outstanding, ExchangeandFederal U.S. Reserve Treasury Amount of Japanese yen 508.2 720.4 Sept. 28, 2001 ArrangementsCurrencyStabilization Fund facility Total -1,157.2 -1,161.4 U.S. Treasury MarketSystemReserveFederal AccountOpen Period and Banitemk of :Mexic o Realized profits and 3,000 .0 losses Exchange from foreign currency sales, Stabilization June 29, 2001-Sept. 28, 2001 Total 3,000 .0 Fund Euro .0 .0 Japanese yen .0 .0 Note 1. Includes temporary augmentation of existing $2 billion swap arrangement. Note 2. Temporary thirty-day swap arrangement. Total .0 .0 U.S. Treasury MarketSystemReserveFederal AccountOpen Period and item: Valuation profits and losses on Exchange outstanding assets and liabilities, Stabilization Sept. 28, 2001 Fund Euro 505.9 505.5 Table 4. Daily European Central Bank swap facility activity, Japanese yen 349.2 349.2 September 12-15, 2001 Millions of dollars Total 855.1 854.7

Amount Date Drawings Repayments outstanding

Sept. 12 5.4 .0 5.4 Sept. 13 14.147 .0 19.547 Sept. 14 3.915 14.147 9.315 Sept. 15 .0 9.315 .0