The Shift from QE to QT Has Hurt EM

In response to the Global Financial Crisis of 2008-2009, the U.S. Federal Reserve adopted a Quantitative Easing (QE) program that was designed to depress interest rates and stimulate the economy. As U.S. rates declined, the emerging markets (EM) benefitted from corresponding rate reductions.

New capital flowed into emerging markets, and they didn’t shy away from accepting it by issuing U.S. dollar debt. This new influx of capital supported more rapid growth in emerging markets than they could have otherwise achieved.

Now, nine years after the crisis, the United States has been on more of a normalization. The shift in monetary policy – to Quantitative Tightening (QT) – is reining in the liquidity that QE once provided. Emerging markets that had come to rely on external capital to fuel their growth are now having to adjust to a new world order.

Exhibit 1: After QE Began, Emerging Markets

A Closer Look: The Change in U.S. Policy and Its Impact

With Quantitative Easing, the Fed became a supplier of capital. It injected capital into the system as it bought up bonds, and that action helped drive interest rates lower.

Recently, as U.S. economic growth has accelerated, the Fed has turned to a new policy – Quantitative Tightening – and it has become a consumer of capital. The Fed has been taking money out of the system by selling bonds on its balance sheet or letting them mature – actions that push short-term rates higher.

The U.S. economy, of course, is impacted by fiscal policy as well as monetary policy. In the midst of an already strong economy, the U.S. government has taken action to further stimulate the economy and substantially increased the government budget deficit. A deficit occurs any time the government’s budget and spending exceed its receipts, and the recent tax cuts from the stimulus reduce the government’s tax receipts. The deficit must be funded by more borrowing, which for the government means issuing more bonds.

More deficit spending, as well as Quantitative Tightening, increases the supply of U.S. dollar- denominated bonds in the market. An increase in the supply of almost anything typically drives prices lower, and, in the case of bonds, lower prices mean higher yields. Using the amount of new credit in the markets in 2017 as a baseline, we do not foresee a slowdown in supply growth any time soon.

Exhibit 2: Deficit Spending and QT Will Increase the Supply of Bonds (and Drive Yields Higher)

Accelerating U.S. Growth and Slowing EM Growth Has Caused Capital to Flow out of EM

It only seems natural that an opposite scenario would play out once a policy that pushed investors out of the United States and into EM (QE) was reversed (QT). That has happened. As higher rates in the U.S. make U.S. debt more attractive, investors are being drawn away from EM.

The impact of this reversal of fortunes has a compounding negative effect. More supply of U.S. bonds means less demand for EM bonds, and therefore higher EM yields. Higher EM yields mean higher EM debt servicing costs, tighter EM financial conditions, and slower EM growth.

While it is sometimes convenient to talk about the emerging markets broadly, it is always important to remember that EM encompasses a vast number of countries with considerably different circumstances. As Exhibit 3 illustrates, some countries have relatively high levels of external debt in relation to their GDP, while for other countries debt levels are at more manageable levels.

The fact that some EM countries still have low levels of economic growth, even after a period of robust credit expansion, suggests major structural problems within their economies.

While this situation may create problems for some investors who own debt in these markets, we believe that, for others, it may create opportunities.

Exhibit 3: Levels of Debt Vary Considerably Across EM