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The QE3 honeymoon may be disappointingly brief for emerging markets. The U.S. Federal Reserve's promise to buy mortgage-backed bonds into the indefinite future could lift all boats for a while. But the flood of dollars might soon frighten investors, as well as vex central bankers everywhere but the United States.

It's no mystery what happens when the Fed buys bonds with newly conjured dollars: anything but dollars tends to rise. In the year after QE1 in late 2008, emerging market bond yields fell, gold rose 56 per cent, oil climbed 70 per cent and MSCI's index of Asian stocks rose 65 per cent. A similar trend was under way after QE2 in late 2010, until July, 2011, when the Fed stopped buying more bonds and the European crisis boiled over.

Now the Fed has promised to create $40-billion (U.S.) a month until it deems that the U.S. labour market has responded sufficiently. That opens the prospect of a limitless supply of hot money, driving the prices of risky assets ever higher. The Hong Kong Monetary Authority is already worrying about the effect on the city's property market.

For central bankers, all that hot money turns monetary policy on its head: If inflation is a problem, cutting policy rates will reduce the allure of their country's assets and thus raise funding costs. But if growth is slowing, they can hold rates or even raise them, and let the incoming hot money drive stocks up and corporate borrowing costs down.

But after two rounds of artificial currency injections, investors are becoming sensitized. All too soon, they'll be looking to see if QE3 is working.

If it's not reviving growth or inflation, they are likely to forsake commodities and emerging-market stocks for higheryielding bonds from fiscal havens like Australia and Indonesia.

And if growth stays sluggish but inflation perks up, they'll hunt for higher-yielding debt in less export-dependent economies with relatively strong finances – such as Japan and Argentina.

The most dramatic switch would occur if quantitative easing seems to be working. Then investors may have to resort to a radical, almost forgotten strategy: searching for relative value.

Wayne Arnold

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