U.S. Liquid Government Liabilities and Emerging Market Capital Flows

We identify the liquidity channel through which Federal Reserve quantitative easing (QE) and quantitative tightening (QT) affect capital flows to emerging markets. Using weekly data on the Fed's purchases and sales of long-term U.S. Treasury securities, we find that large purchases lead to a significant increase in capital flows to emerging markets, and that sales have the reverse effect. We then show that QE lowers, and QT raises, the convenience yield on U.S. Treasuries, measured by covered interest parity deviations, and that the induced changes in the convenience yield drive the capital flow responses. Our model based on liquidity rationalizes these findings: QE shifts publicly held government debt toward more liquid assets, providing investors a greater buffer against the risk of low consumption. Better insured through liquid asset holdings, investors are willing to increase illiquid investments, including lending to emerging markets.