Will the Fed Have to Save Emerging Markets with QE4?

September 3, 2015

The risk-off tide is rising, and sand castles of QE will only hold the tide back for a brief period of apparent calm.

A funny thing happened on the way to permanently expanding global markets: unintended consequences. Borrowing cheap, abundant U.S. dollars seemed like a good idea when the dollar was declining, and few voiced any concern when $9 trillion was borrowed in USD-denominated debt around the world in the years since 2009.

Few saw the possibility of the USD rising, or that if it did appreciate against other currencies, that the blowback would destabilize the global economy.

It turns out a strengthening USD has triggered capital flight as other currencies devalue. Anyone propping up their currency to stem the flood tide faces another unintended consequence--a faltering export sector: China: Doomed If You Do, Doomed If You Don't (September 1, 2015).

Meanwhile, the Imperial economy is suffering its own spate of unintended consequences, notably rising yields, a.k.a. quantitative tightening. As emerging markets and nations attempting to defend their currency pegs to the USD sell U.S. Treasury bonds (which have been held as foreign exchange reserves), the yields on the Treasuries rise as a matter of supply and demand.

As supply increases, sellers must offer higher yields to entice buyers to soak up the inventory.

This increase in yields reverses the primary effect of quantitative easing, i.e. declining yields/interest rates in the U.S.

This dynamic undermines both the emerging markets and the U.S. Emerging markets are not really restored to growth by selling Treasuries; the strong dollar continues to crush their currencies and dampen growth, as assets must be sold to pay back debt borrowed in USD.

Rising rates threaten the feeble U.S. "recovery" as well.

So what's the solution to this inconvenient dynamic? QE4, of course. Why would the Federal Reserve launch QE4, if not to push rates down in the U.S.?

The primary reason is not yield suppression in the U.S. but to provide sufficient USD liquidity to everyone in the world who borrowed USD-denominated debt. If dollars are scarce, emerging market assets will have to be sold, and the demand for USD will push the USD higher vs. other currencies.

This creates an unvirtuous cycle in which the strengthening dollar makes it increasingly onerous to pay back dollar-denominated debt, which further pressures emerging market currencies and asset valuations.

In the long view, this is the cost of issuing the reserve currency: the U.S. central bank doesn't just have to bail out American debtors and speculators--it also has to bail out international debtors and speculators who gambled with borrowed USD.

The only way to break this unvirtuous cycle is to flood the world with U.S. dollars so borrowers can refinance without having to liquidate assets denominated in other currencies.

One way to issue more dollars is quantitative easing, in one form or another.

This will suppress the rise of the U.S. dollar and give a reprieve to borrowers of USD-denominated debt. But the reprieve will be temporary, as the "growth story" based on borrowing cheap USD to invest in emerging markets and China is broken.

The risk-off tide is rising, and sand castles of QE will only hold the tide back for a brief period of apparent calm. QE4 will fix nothing on a fundamental level.

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