An Anomaly Emerges In Emerging Markets

Earlier on Monday in “‘People Are Going To See There’s No Liquidity’: EM ETFs Face ‘Minsky Moment’,” we highlighted a new FT piece that flags many of the same risks we’ve been pounding the table on for months with regard to HY and EM bond ETFs.

Simply put: the ETFs promise all-day liquidity while the underlying bonds aren’t liquid. So you know, there’s an inherent liquidity mismatch there and in the event we ever get unidirectional flows (i.e. everyone selling) and no one (e.g. APs) is willing to inventory the bonds, well then we’ll get a firesale.

The reason it’s worth mentioning that right now is simple: EM bond funds have experienced enormous inflows for quite some time and with DM central banks looking to tighten just as geopolitical risk rises, it’s looking more and more like those inflows could go into reverse.

Sure enough, in a good piece out this afternoon, Bloomberg notes that investors pulled some $1.2 billion from the iShares JPMorgan USD Emerging Markets Bond ETF in the past two weeks alone, with a record $827 million fleeing the fund last week:

EMB

That’s more than a quarter of the fund’s YTD inflows.

But the really interesting visual is this one, which shows that EM government bonds are trading wide to corporates:

EMSovVsCor

The reason: well, probably the fact that thanks in part to ETFs, there’s more secondary liquidity for sovereigns so that’s where the selling starts, but as Uday Patnaik, who helps oversee more than $1 billion of developing-nation debt at Legal & General Investment Management Ltd told Bloomberg, “if you believe we could go wider in spread, then you have to think that at some point the outflows will also occur in corporates.”

Right.

Ultimately though, the takeaway is that outflows in general are picking up, which means that as we warned in the post linked here at the outset, these ETFs are going to be tested sometime in the not-so-distant future unless i) DM central banks get cold feet and allow the carry party to continue, ii) geopolitical risk and idiosyncratic country risk subside, or iii) both.

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