A paper of the University of St. Gallen shows that foreign exchange liquidity has been highly correlated across currency pairs, apparently more so than in equity markets. Liquidity correlation has been strongest in developed FX markets and particularly in volatile currency pairs. Bond and equity markets seem to have a bearing on systematic FX liquidity. Feedback loops between market illiquidity and funding constraints can escalate into fire sales. Riskier currency pairs, and particularly those related to carry trades, are more susceptible to liquidity shocks.

“Understanding FX Liquidity”, Nina Karnaukh, Angelo Ranaldo, and Paul Soederlind
University of St. Gallen, Working Papers on Finance, 2013/15
http://www1.vwa.unisg.ch/RePEc/usg/sfwpfi/WPF-1315.pdf

The below are excerpts from the paper.

Why and how to measure FX liquidity

“The FX market is the world’s largest financial market with a daily average trading volume of four trillion U.S. dollars in 2013…Liquidity in the FX market is crucial to guarantee efficiency and arbitrage conditions in many other markets including bonds and derivatives….An in-depth understanding of FX liquidity is important for several reasons. First, illiquidity erodes asset returns and liquidity risk demands a premium…Second, a new strand of theoretical models (thereafter called “liquidity spirals theories”)… show that financial crises are typically associated with unwinding carry trade and liquidity drops.”

“We need to construct reliable liquidity measures from price data that are readily available on a daily frequency…We use two main sources of data: first, low-frequency data from Thomson Reuters from which we compute many low-frequency liquidity measures widely used in the equity and bond literature. Second, high-frequency and sophisticated data from Electronic Broking Services (EBS), which is the leading platform for FX spot interdealer trading, from which we derive the benchmark measures of FX liquidity. Then, we compare the low-frequency and high-frequency measures on the nine mostly traded currency pairs over the period January 2007 to May 2012.”

Stylized facts from recent years

“Commonality is particularly remarkable for developed currencies and in highly volatile markets…The average R-square [squared correlation of daily liquidity measures] across our sample of 40 currencies is 36%. Only seven exchange rates have an R-square lower than 10%, several of which involved pegged currencies, suggesting that liquidity co-moves for the vast majority of the currencies. This implies that there are periods when the entire FX market is systematically illiquid or liquid…commonality of the FX market is stronger than that found in the stock market literature…[Moreover] FX commonality is stronger for developed currencies.”

“We also find that FX liquidity co-moves with stock and bond market liquidity suggesting cross-market liquidity movements….FX liquidity can be related to returns of FX and other assets such as bonds and stocks…we can explain much of the variation in FX systematic liquidity..We find that FX systematic illiquidity can be explained by increases of risk in stock and bond markets in addition to FX risk–consistent with flight-to-quality or flight to- liquidity episodes. Thus, we find…cross-markets linkages not only via volatility but via illiquidity as well.”

“Our results are also in line with the liquidity spirals theories, i.e. an adverse shock and an increase in volatility trigger feedback loops between funding constraints and market illiquidity….funding constraints and market illiquidity can generate spirals through fire-sales and increased risk. This mechanism can spill over across various asset classes including FX markets, creating contagion and commonality in illiquidity.”

“We find that riskier currencies are more exposed to liquidity drops. More specifically, liquidity of riskier currencies tends to decrease more with an increase of risk in stock and bond market as well as tighter funding constraints…This pattern materializes in three ways. First, an increase in stock volatility and in default spreads is associated with more severe liquidity drops for those exchange rates that depreciate more against the U.S. dollar and for those exchange rates with large volatility increases. Hence, the FX return risk and volatility risk strengthen the effects of the stock market and corporate bond risks. Second, the liquidity of those currencies more exposed to the carry trade risk deteriorates more with an increase of corporate bonds yields. Third, the liquidity risk appears to be more discernible in terms of funding liquidity risk, that is, as the TED spread increases, the liquidity tends to evaporate more for those currencies with stronger commonality.”