Ashmore’s Jan Dehn: The failure of QE‏

27th April 2015

Jan Dehn, head of research at Ashmore discusses why Quantitative Easing (QE) is failing as instead of funneling funds into the real economy, the policy is inflating bubbles in both equity and bond markets in the Heavily Indebted Developed Countries (HIDCs)…

Lately, as many HIDC bond yields approach zero, QE money is migrating into currency markets where it is causing growing volatility, which is now beginning to create serious economic problems. These unintended consequences are undermining the effectiveness of QE and the failure of governments to reform and deleverage is compounding the problem. Today, a major attraction of Emerging Markets (EM) fixed income investment is one of insurance against large permanent loss – in EM you can still be confident that you are not buying into a bubble.

Turning policies of the 1930s on their head

The decision to respond to the collapse of the ‘Greenspan Bubble’ by slashing interest rates and printing money – QE – stands in sharp contrast to the policies that were adopted during the Great Depression in the 1930s. Instead of tightening monetary policy and forcing the economy into sharp economic contraction, the Fed Chairman at the time, Ben Bernanke, adopted a policy of extreme monetary policy easing to facilitate a very gradual adjustment of the underlying economy. Broadly the policies have also been enacted in response to similar economic problems in other HIDCs, including Japan and the Eurozone.

Good intentions…

The basic principle behind QE is simple enough. In order to stimulate demand money is printed to buy government bonds. By pushing down yields, not just at the short end of the curve but also further out, money is expected to move into the real economy in pursuit of better returns, thus stimulating demand and bringing about a sustained economic recovery.

…but unintended consequences

Unfortunately, QE has delivered a number of unintended consequences that now threaten to undermine its effectiveness. Rather than finding its way into the real economy, QE money has fuelled a bubble in bond and stock markets and is now also entering the currency markets, where it is contributing to greater and greater volatility. The bubbles and the associated uncertainty are undermining the economic recovery which QE was supposed to engender.

Currencies are now beating bonds

Lately QE has also begun to sow the seeds of its own failure in the global currency markets. As an investment, a currency actually becomes superior to a bond when bond yields fall to zero. At zero yields, currencies have two distinct advantages over bonds in that they cannot default and they are vastly more liquid.

In addition, currency trades tend to be wonderfully auto-correlated, particularly in the big three currencies (EUR, JPY and USD). This means that popular consensus trades can last for months, even years, which is enough time for investors to jump on the bandwagon and make some money even if they don’t catch the exact turning points. It should therefore not surprise that currencies have emerged as the single most dominant force in shaping global market sentiment today.


QE’s tendency to elevate a small number of global currencies to the status of global market sentiment drivers with scant regard to underlying fundamentals is already having serious adverse economic consequences. Some EM countries have experienced dramatic – and in some cases entirely unwarranted – currency volatility, including withdrawal of funding from their local markets by fearful international investors. This was particularly evident during the 2013 Taper Tantrum, where such outflows caused a 200bps increase in local bond yields, which in turn shaved 50bps off EM average growth in 2014. Fortunately, most EM countries had – and still have – the means to handle such volatility without too much fundamental distress due to their large FX reserves and generally strong economic fundamentals.

The unintended consequence

What is it about QE that has generated such negative effects that the policy is now in danger of being an outright failure? Importantly, the central bank architects of QE did not pay enough attention to the risk of speculation, myopia and herd behaviour among financial investors. Financial investments consist of both yield and capital gain (or loss). Simply driving bond yields to zero does not guarantee that financial markets plough money into the real economy. Instead, investors have chased capital gains in both stock and bond markets and, lately, as bond market yields have fallen to zero, increasingly also in currency markets – the most myopic and herd-driven of all. In this way, QE has actually discouraged the recovery by inflating bubbles, increasing myopia and raising the level of volatility in currency markets rather than encouraging real investments to support the economic recovery.

Unless they get serious about fixing their underlying economic problems, notably the debt overhang, it is likely that QE’s euphoric effects will wane. The response will likely be more QE but each application becomes less effective and the addition worsens. Volatility and the risk of bubbles both increase. The biggest risk is that ordinary people see through the money illusion that lies behind QE, so that they increase savings as they perceive big losses of future income ahead.

QE will only properly succeed as an economic rescue operation if it leads to inflation. The entire Western world is today actively pursuing policies that could, theoretically, result in a sudden resurgence of inflation. The US in particular has undertaken policies that give hope that inflation could resurface within the next couple of years, notably through bank recapitalisation and the clever use of the Fed’s balance sheet to help household deleverage.

If inflation were to resurface today, aided by QE, the immediate damage would probably be significant, because inflation is entirely unexpected and would force upon markets some serious reassessments, including considering the prospects for further financial repression, but also a re-pricing of the US yield curve and the USD. Ultimately, however, these would be temporary problems. QE will only be judged a success if, from the rubble, inflation and currency realignment emerge to help deal with the debt overhang and restore external competitiveness.

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