Is the HKD anchor safe? How could HIBOR move from here? EJINSIGHT

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The Hong Kong dollar has recently hovered above the weak end of its band, raising concerns and questions about the viability of the peg to the US dollar. We don’t believe the anchor is in danger – not now or in the near future. However, to maintain the peg, interest rates could continue to climb to uncomfortable levels. Compared to 2016-18, a more hawkish Fed and subdued growth in China could lead to increased capital outflows from Hong Kong, keeping USD/HKD near 7.85 and rapidly rising HIBOR over the past 2 – next 3 months. This would benefit banks but would weigh on real estate.

The Hong Kong dollar initially started to depreciate from 7.75 (the strongest side of its trading band) in 2021 when Hong Kong-listed stocks saw exits due to regulatory risks, before weakening recently and touching 7.85 (the weakest side of the band) on multiple occasions. The Hong Kong Monetary Authority (HKMA) began to intervene in May and bought a total of around HKD 18 billion from the market. However, the currency pair continued to hover around 7.85 and the outflows persisted. Given the challenging growth outlook for Hong Kong and mainland China, some investors have begun to worry that the HKD peg may be under threat.

The ankle is not in danger

The exchange rate mechanism that pegs the Hong Kong dollar to the US dollar is managed by a “currency board”. The main features of the system are that the Hong Kong Monetary Authority (HKMA) must follow US monetary policy and must maintain foreign exchange (FX) reserves equal to or greater than the existing money supply. Therefore, under a well-run system, every HKD banknote should be able to be exchanged into USD. Also, the HKMA cannot set discretionary monetary policy.

So how does it work? If HKD’s liquidity runs out due to capital outflows, money supply contracts and interest rates (HIBOR) naturally rise. This draws money into the system, creating a natural balance between interest rates, the exchange rate, and the money supply.

Exchange rate stability is maintained by automatic adjustment of interest rates, where interest rates – rather than the exchange rate – adjust to the inflow or outflow of capital. The disadvantages of this system are that the HKMA cannot implement independent monetary policies, cannot set interest rates, and cannot expand or shrink its balance sheet to reflect local conditions.

For illustrative purposes, the chart below shows the ratio of foreign exchange reserves held by the HKMA that are designated to defend the peg – namely backing assets – of Hong Kong’s monetary base. While the ratio fell from a 2020 high as base money growth under Covid relief outpaced growth in foreign reserves, it continues to hover comfortably above 100% .

We see Hibor rising significantly from here

Given the necessary links to US monetary policy, HIBOR should rise at a time when the economy does not need higher rates, and it could rise sharply in the coming months. The ankle mechanism is the main driver. As mentioned above, interest rates adjust with flows – when HKD liquidity runs out due to outflows, Hibor will automatically rise to attract the money. It is already happening.

Hibor has started to rally alongside USD rates since the Fed’s first hike in March. However, the rise was too slow to catch up with the rapid rise in US yields due to the jump in aggregate balances under very accommodative monetary conditions over the past two years, and as a result credit spreads remained negative.

Compared to previous cycles of Fed tightening, this time we see a more challenging backdrop, given: 1) a much more hawkish Fed; and 2) slowing Chinese growth. Capital outflow pressures could therefore be more intense compared to the last Fed hike cycle. We expect capital outflows to lower the overall balance to less than HKD 100 billion (from HKD 330 billion currently), potentially in August, as the Fed has already hiked rates by 75 basis points in the June FOMC meeting and is set to offer hikes of at least 75 basis points at the July FOMC meeting this week. These drivers will likely end up draining liquidity from the system and driving Hibor rates up sharply.

It would be logical to expect a tightening of USD-HKD yield spreads in the 2nd half of 2022. The current gap between the federal funds rate and HIBOR overnight at 79 basis points seems unsustainable. Historical experience suggests that the spread between the federal funds rate and HIBOR tends to narrow significantly when the overall balance falls below HKD 100 billion.

This is a bad time for higher interest rates as Hong Kong’s macroeconomic environment remains challenging. The economy contracted 4% year-on-year in the first quarter as recurring Covid restrictions severely disrupted consumption, adding to the slowdown in the lack of inbound tourism. Growth has been irregular for some years. The economy recorded negative growth in 2019 and 2020. The rebound in 2021 was strong thanks to generous fiscal easing and strong exports, but was again disrupted by shutdowns earlier this year. While demand may pick up as the economy reopens and a new round of cash grants are distributed, the negative outlook for external demand and the closure of the border with China pose ongoing risks to the growth. With tighter financial conditions going forward, a rebound in the third quarter could be weaker than in 2021.

Investment implications

USD/HKD will likely continue to trade near the weak side of the band (ie 7.85) in the near term. We believe the LIBOR-HIBOR differential will close more significantly in the coming months once liquidity begins to dry up.

Although the composition of the local stock market does not particularly reflect the national economy, certain segments could see a more direct impact from rising interest rates. For example, Hong Kong banks could be a key beneficiary of interest rate hikes, as net interest margin (NIM) has been shown to be highly correlated with HIBOR and LIBOR over the past 10 years. Hong Kong banks’ NIM sensitivity is expected to be higher in coming cycles than before, due to record CASA ratios (i.e. the ratio of current account deposits and savings to total deposits). We expect the underlying margin trend to improve over the coming quarters, driven by higher deposit spreads. Hong Kong developers may face headwinds from rising interest rates. In addition to slower GDP growth, affordability for homebuyers would be affected by higher mortgage rates, leading to lower transaction volumes in the real estate market and potential weakness in house prices.

From a multi-asset perspective, we continue to argue for an addition to core fixed income. Although yields have fallen, in our view expected returns in a soft landing scenario are comparable to those of equities and in a recession scenario they should exceed equities. From a risk-adjusted perspective, core fixed income securities (investment grade corporate bonds and US Treasuries) remain our highest conviction call. Stocks are pricing in about 60-70% of an average recession, so there is certainly some struggle in price already, but we are seeing continued downside risk to earnings and still above average stock positioning.

— Contact us at [email protected]

Alex Wolf

Head of Asia Investment Strategy, JP Morgan Private Bank

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