--Fed: Dollar appreciated 3.33% against the euro in Q2
--Fed: Dollar depreciated 1.2% against the yen in Q2 2001
--Fed: Perceptions of US economic rebound supported dlr vs euro
--Fed: Euro, yen FX reserves at $14.4 bln in Q2
--Fed: Treasury euro, yen FX reserves at $14.4 bln in Q2

By Cornelius Luca
New York, Aug. 2 (BridgeNews) - The Federal Reserve of New York confirmed Thursday that the U.S. monetary authorities did not intervene in the foreign exchange markets during the April-June quarter of 2001. Perceptions that the U.S. economy would emerge from the downturn sooner than the euro zone underpinned the dollar versus the euro, the Fed said.
During the second quarter, the Federal Open Market Committee (FOMC) lowered its target federal funds rate a total of 125 basis points from 5.0% to 3.75%. Market participants debated the extent of the U.S. economic slowing and considered the scope for any future easing in monetary policy, the Fed report noted.
Market discussion on the outlook for inflation contributed to Treasury curve steepening. Over the quarter, the two-year Treasury yield rose 6 basis points while the yield on the 10-year note rose 43 basis points, widening the spread between the two- and 10-year yields by 40 basis points to 117 basis points, the Fed said.
The release of stronger-than-expected data for GDP growth in the first quarter and several first-quarter earnings announcements contributed to a temporary revival in investor sentiment. However, other U.S. economic data releases, such as the March and April employment reports, suggested continued softening in some sectors of the economy, heightening expectations for further easing of monetary policy by the FOMC. Directional trends in major currency pairs were largely muted and the dollar closed the quarter nearly unchanged on a trade-weighted basis, the Fed said. A notable decline in option implied volatility across maturities in G-3 currencies suggested lower investor demand for protection against sharp exchange rate movements and a greater level of comfort 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 yen to 125 yen for most of the quarter.
One-year dollar-yen and euro-dollar implied volatilities reached their lowest levels in over a year and ended the quarter 2.5% and 2.3% lower at 10.65% and 10.9%, respectively.
The euro depreciated 3.2% against the dollar and 4.4% against the yen, the quarterly report noted. After trading in a relatively narrow range against the dollar during the first half of the quarter, the single currency 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 weighed on sentiment toward the single currency. Net cross-border investment outflows and a shift in investor positioning further pressured the euro. According to the ECB, the net outflow of direct and portfolio investment from the euro area totaled 20.8 billion euros in April, following an 86 billion euro outflow in the first quarter of 2001. The data seemed to corroborate anecdotal market reports that highlighted Japanese disinvestment from the euro area as the currency-adjusted value of these investments deteriorated.
Additionally, following the yen's appreciation in May, International Monetary Market positioning data showed net euro positions by speculative investors turned short for the first time in nine months.
Early in the quarter, euro-area economic data indicated that growth was slowing and price pressures were rising, the Fed said. 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 by 25 basis points, bringing the two-week marginal refinancing rate to 4.50%.
Later in the second quarter, however, euro-area economic data continued to show signs of rising inflation, 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%, while the yield implied by the March 2002 contract rose only 11 basis points. Meanwhile, euro-area data releases showed continued deceleration in economic activity, most notably in Germany.
Although the FOMC eased policy more than the ECB, long-dated interest rate differentials remained in favor of the dollar in the second quarter, the Fed noted. Following the ECB's May 10 move to ease rates, the spread between the 10-year dollar and euro swap rates reached its widest level for the year at 91 basis points. The euro depreciated 4.6% against the dollar in May after the policy change.
The yen appreciated as much as 6.0% and 10.0% against the dollar and the euro, before depreciating to end the quarter 1.2% and 4.6% stronger against the dollar and the euro, respectively, according to the quarterly report. Investor sentiment toward Japan improved after Japan's ruling party selected a new Prime Minister in April, and investor position adjustments 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 contributed to the yen's subsequent decline against the dollar and the euro.
In mid-May, the euro's weakness and resulting Japanese investor losses reportedly led to a retrenchment of European investments by Japanese investors.
The yen's initial appreciation sparked a spate of short yen position covering, 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 yen levels against the dollar and the euro, respectively, the Fed noted.
In June, this price action was largely reversed: the yen weakened 4.5% against the euro and 4.9% against the dollar, as post-election enthusiasm and initial hopes for specific structural reform plans began to ebb. In addition, market participants interpreted a Japanese newspaper report as suggesting 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 Fed.
At the end of the second quarter, the values of euro and Japanese yen reserve holdings based on exchange rates as of March 31, 2001, totaled $14.389 billion for the Federal Reserve System and $14.386 billion for the U.S. Treasury's Exchange Stabilization Fund.