Academic journal article Federal Reserve Bulletin

Treasury and Federal Reserve Foreign Exchange Operations

Academic journal article Federal Reserve Bulletin

Treasury and Federal Reserve Foreign Exchange Operations

Article excerpt

This quarterly report describes U.S. Treasury and System foreign exchange operations for the period from July through September 1998. It was presented by Peter R. Fisher, Executive Vice President. Federal Reserve Bank of New York, and Manager, System Open Market Account. Jason J. Bonanca was primarily responsible for preparation of the report.

During the third quarter of 1998, the dollar depreciated 1.7 percent against the Japanese yen and 7.8 percent against the German mark (charts 1 and 2). Against the mark, the dollar continued to trade in relatively narrow ranges during the first half of the period. Subsequently, however, the dollar dropped sharply amid increasing turmoil in global financial markets and shifting expectations for economic growth and interest rate policy. Against the yen, the dollar steadily appreciated throughout the first half of the quarter, reaching new eight-year highs, as market participants reacted pessimistically to political uncertainty and financial-sector difficulties in Japan. Later in the period, the dollar's gains were more than reversed as market participants unwound short yen positions in an environment of increasing risk aversion. The U.S. monetary authorities did not intervene in the foreign exchange markets during the quarter.



During the first half of the quarter, market participants expected that near-term U.S. interest rate policy would remain unchanged. The economic slowdown in Asia was expected to counterbalance ongoing, if moderating, strength in U.S. domestic demand. However, continued financial and economic weakness in Japan and developments in emerging markets--particularly the deteriorating financial situation in Russia--helped to support U.S. Treasury prices during the first weeks in the quarter. Until the middle of August, the thirty-year Treasury bond yield traded consistently below 5.80 percent, near the bottom of its 1998 range (chart 3).


Investor aversion to risk intensified sharply after Russia's declaration of a debt moratorium and an effective devaluation of the ruble on August 17. Losses in Russian markets and a dramatic widening of risk premiums led to successive waves of selling in emerging-market assets. Dollar-denominated, emerging-market yield spreads over Treasuries rose to their highest levels since early 1995, and sales of emerging-market currencies ensued as investors shed positions in local markets. These outflows led to increasing pressures on other markets, particularly those with fixed exchange rate regimes. Mounting strains on the Hong Kong dollar led to speculation regarding another series of currency devaluations in Asia. Meanwhile, increasing capital outflows from Brazil, as well as devaluations in Colombia and Ecuador, raised concerns about stability in Latin America. Sensitivity to the risk of sovereign events was exacerbated by Malaysia's announcement of capital controls and a new fixed exchange rate regime on September 1, as well as Hong Kong's decision to intervene in its equity market. In this environment, demand for U.S. Treasuries soared, with the thirty-year bond yield declining, to as low as 4.96, on September 30. Meanwhile, U.S. equities began to post sharp declines, responding to mounting turmoil in emerging markets and weaker-than-expected corporate earnings. European shares also weakened; the German DAX declined 24.2 percent over the period.

The sharp downward adjustment in asset prices in emerging markets accelerated as leveraged investors were forced to liquidate positions to meet margin calls. Risk aversion grew, as market participants anticipated that rapidly accruing losses might lead to a contraction of credit within the investment community. Further, the speed of the declines led to substantially illiquid trading conditions, which exacerbated volatility in already unsteady markets. …

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