Emerging market liquidity dented by Fed

Market liquidity can be a somewhat nebulous concept. It is difficult to measure, particularly in OTC derivative markets.

But we can be fairly sure that there was one asset class where liquidity was impaired this week: emerging market credit. Take China, for example. The bid/ask spread on China's 5-year CDS shot up from 4bps at the beginning of the week to nearly 9bps on Thursday, according to data from Markit's liquidity metrics.

One might say this is to be expected given the sharp widening in spreads this week. But China was trading around its current level this time last year, and its bid-ask spread was only 3bps. It appears that the sudden shock delivered by China's dysfunctional interbank market had a serious impact on credit market liquidity.

A marked increase in the number of quotes received through Markit's parsing system would suggest that there was considerable interest in China CDS. However, the large rise in the bid/ask would indicate that many participants were not overly keen on trading this credit. China is a liquid sovereign - it has a Markit Liquidity Score of '1' - but we will have to wait for DTCC data next week to get a better idea of activity.

China's banking problems are real, and they are clearly having an impact beyond its borders. But it was the Fed that really upset emerging market conditions. The central bank sent a clear signal that it is preparing to taper QE - conditional on positive labour market data - and this has added to capital flight from the asset class.

Liquidity in sovereigns from Asia to Latin America has been affected by the Fed's perceived policy shift. Ukraine CDS typically has a bid/ask spread of around 25bps - it is not a very liquid credit (Markit Liquidity Score of '2'). On Thursday, after its CDS spreads widened from 754bps to 833bps, it was trading with an average bid/ask spread of 58bps.

The magnitude of these moves perhaps shows how some participants may have become complacent about liquidity in emerging markets. We are set for a volatile summer, and further liquidity disruptions are probably inevitable as the markets get QE withdrawal symptoms.

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