Monday, 7 September 2015

HKD thoughts - Strongest USD peg in the world...or most convex macro hedge?

"Be able to defend your arguments in a rational way. Otherwise, all you have is an opinion." - Marilyn vos Savant, American writer

Even during the height of the Asian crisis in 1997, the HKD peg was never challenged, shorting the currency is similar to shorting the Japanese long bond JGB, a true "widowmaker" trade.

We have a growing interest in evaluating the potential consequences of a Chinese devaluation of the Yuan (CNY). 

Like our good friends at Rcube Global Asset Management, we remain convinced it is on the cards particularly with the growing noise coming from government officials/agencies expecting at least a devaluation of 10% in 2016/2017.

The below graph shows the pressure on Hong Kong's exchange rate system: forex reserves have been exploding since 2008:

-source Sem Huizer - Twitter

For now there is continued buying pressure on HKD. This has led on Tuesday, the Hong Kong Monetary Authority to intervene and buy $1.2 billion at HKD 7.75, the upper limit of the band of the peg to relieve some pressure on the HKD. This marked the second intervention of the HKMA since April according to Bloomberg:
"Hong Kong’s de facto central bank stepped in for the first time in more than four months to prevent the city’s currency from breaking out of the strong end of its pegged range against the U.S. dollar. The Hong Kong Monetary Authority said it bought $1.2 billion late Tuesday at HK$7.75 a dollar, the upper limit of a band that triggers intervention, taking today’s injection to $2 billion. It last intervened in April, buying $9.2 billion in total during the month. The HKMA “will monitor the market developments closely and maintain the stability of the Hong Kong dollar,” it said in a statement.
Hong Kong’s dollar is drawing funds as last month’s surprise yuan devaluation and the prospect of higher U.S. interest rates push currencies lower across Asia’s developing economies. The weakening of the yuan was followed by exchange-rate shifts in Kazakhstan and Vietnam, making investors nervous about regime changes in other currencies.
“The demand for Hong Kong dollars comes from the unwinding of yuan after the devaluation,” said Raymond Yeung, a senior economist at Australia & New Zealand Banking Group Ltd. in Hong Kong. “It also reflects demand for safe-haven assets as Hong Kong’s dollar is pegged to the U.S. dollar. We aren’t seeing a huge amount of speculation on changes in the peg.”
- source Bloomberg
The pressure to devalue the HKD is going to increase with the loss of competitivity of Hong Kong versus its Asian peers as its currency has been soaring in conjunction with the US dollar.

The more we think about it, the more it appears to us that Hong-Kong is the most exposed Asian economy to such a currency move. We also share our concerns with UBS who recently published a very interesting note entitled "What if the CNY depreciated by 10%?":
"The increasingly difficult position of Hong Kong
In our view, no equity market in APAC is more vulnerable to a potential 10% devaluation of the RMB than Hong Kong. We are currently underweight Hong Kong equities, after Japan, APAC's second best performer this year.
As it stands Hong Kong has seen a significant increase in private sector credit to GDP in the last few years. 
The real effective exchange rate has increased 10% since 2007, while the economy faces the prospect of rising US rates. 
To experience on top of this 10% devaluation from its major trading partner and the deflation this implies, is a challenging combination especially without the ability to lower nominal or real interest rates. For further details on the challenges HK faces, please see our colleague Silvia Liu's note "Hong Kong: near the tipping point?" - source UBS
A weaker CNY would trigger a fall in competitivity for the entire Asian region and would massively impact the retail sector of Hong-Kong with additional fall in the number of visitors from mainland China and even more pressure on property developpers. Hong Kong property sales plunged to 17-month low in August amid increasing economic uncertainty in China. The slowdown in the number of visitors is already visible as per the below chart from Bloomberg:
- source Bloomberg

To be short HKD looks similar today to the interesting trades of the previous months of being long CHF and/or short CNY: These "ultra-convex" positions are often very "cheap" to carry and amounts to betting against pegs being "highly disconnected" from economic "reality.

By looking at what is happening in the FX options market, we noticed that some players have started to look at setting up this "short" trade idea via options as suggested in the below graph displaying 3 months volatility on the HKD:

-graph source Bloomberg

This we think warrants, monitoring in the foreseeable future...

"When men sow the wind it is rational to expect that they will reap the whirlwind." - Frederick Douglass, American author.
Stay tuned!

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