Why QE2 didn’t live up to emerging market expectations

Why QE2 didn’t live up to emerging market expectations

The hope in the markets about the US Federal Reserve’s programme of quantitative easing has been belied. After the Fed’s announcement of its second round of quantitative easing measures (known as QE2) on 4 November, the Sensex reached a close of 21,004 on 5 November. But the benchmark index hasn’t been able to scale that peak again, and is now languishing at levels well below it.

QE2 had three objectives, spelt out by Fed officials. One was to lower interest rates by buying back bonds, another was to increase asset prices, while the third goal was to generate inflationary expectations so that the threat of deflation in the US was averted. Lower interest rates in the US, combined with a weaker dollar, were expected to propel funds out of the US, especially to high-growth emerging markets. In fact, that is precisely what had happened in the run-up to QE2.

Also See Yields have gone up after QE2 (PDF)

At first glance, the objective of reducing interest rates appears to have backfired. For instance, the yield on the 10-year US treasury security, around 2.5% when QE2 was announced, has since gone up to around 3.5%.

But the Fed’s aim was to lower real interest rates, i.e., interest rates adjusted for inflationary expectations. To see what effect QE2 has had on real rates, one has only to check the yields on Treasury Inflation Protected Securities (TIPS), which are, as the name implies, bonds indexed to inflation so as to protect investors from the risk of inflation. Well, even real yields have risen, but not so much as the nominal yield, implying some rise in inflation expectations. The 10-year TIPS, which was yielding around 0.4% at the time of the Fed announcement, now yields 1.15%. The five-year TIPS, which yielded a negative 0.5%, now yields 0.3%.

What have been the other effects? Well, the US dollar hasn’t, contrary to dire predictions, fallen off the cliff. In fact, the opposite has happened—the US dollar index, which was at 75.8 on 4 November, is now around 80.4. The S&P 500, which closed at 1,197 on 3 November, up 3.8%.

What ties up all this data together? It’s the simple fact that the US economy is now showing signs of improvement. Leading indicators are improving, jobless claims show a downward trend, factory production is rising and retail sales are showing gains. It is this improvement in the US economy that accounts for higher bond yields, higher equity prices in the US and a stronger dollar. It’s probably the renewed signs of a US recovery that are also driving commodity prices up, especially copper and crude oil. QE2 has had little to do with it.

The upshot has been a shift out of bond funds into stocks and a move by funds into US equities. Fund-tracker EPFR Global’s latest assessment says that, in the run-up to Christmas, “Flows into equity funds were paced by developed markets fund groups with US Equity Funds to the fore in total USD terms." In contrast, “The expectation that China, despite passing on the opportunity afforded by the latest inflation numbers, will hike interest rates sooner rather than later and Brazil’s talk of additional currency controls prompted many investors to take a step back from emerging markets equity in mid-December."

In short, a recovery in the US and a stronger dollar do not augur well for flows to emerging markets. Foreign institutional investors have been selling in the Indian market. Add to that inflationary pressures generated by higher commodity prices and the odds are the Indian market will have to battle several headwinds in the immediate future.

Graphics by Yogesh Kumar/Mint

We welcome your comments at marktomarket@livemint.com