Window For This Bullish Hong Kong Dollar Trade Is Closing

(Bloomberg) -- Hedge funds may have just weeks left to make good money from the long Hong Kong dollar carry trade.

Local interest rates, which have remained stubbornly high relative to those in the U.S., will fall at a faster pace once a measure of the city’s liquidity pool exceeds HK$100 billion ($12.9 billion), according to Bank of America Corp. At HK$94.7 billion from Wednesday, that threshold is soon approaching. The result would be a narrowing of the Hong Kong dollar’s yield advantage over the greenback, which has persisted since November.

Selling the greenback and using the proceeds to buy Hong Kong dollars had delivered Asia’s highest Sharpe ratio -- a measure of returns adjusted for price swings -- earlier in the year. Now, the Hong Kong dollar carry trade ranks just seventh in the region over the past three weeks. Any unwinding that’s too rapid, however, could lead to a sell-off and send the currency all the way to the weak end of its trading band.

“We are already starting to see some of the long-Hong Kong dollar carry trade lose its charm,” said Claudio Piron, co-head of Asia foreign-exchange and rates strategy at BofA. He predicts the currency will drop to the weak end at 7.85 per greenback by year-end. “When the aggregate balance rises above HK$100 billion, the funding pressures will ease.”

The Hong Kong dollar last month climbed to the strong end of where it can technically trade with the greenback at HK$7.75, for the first time since 2016 on investor appeal with the carry trade. The city’s aggregate balance has soared from HK$54 billion over the past three weeks, as authorities sold local dollars and reduced debt issuance to defend the foreign-exchange peg.

A richer cash supply is also good news for a city mired in a record economic slump and with liquidity pressures arising later this year ahead of planned large stock listings.

While the intervention has helped to lower borrowing costs, it’s not yet aggressive enough to damp the carry trade altogether. Hong Kong’s one-month interbank interest rate -- known as Hibor -- was more than 60 basis points higher than its U.S. counterpart as of Monday, even though it’s at about a third of the level seen at the start of April. The gap reached a two-decade high of more than one percentage point last month.

The liquidity pool will peak this quarter at HK$110 billion, said Samuel Tse, an economist at DBS Bank Ltd., forecasting the Hong Kong dollar will weaken to 7.8 per greenback when the gap between Hibor and U.S. Libor contracts to around 20 basis points. The city’s currency, which is allowed to trade in a range of 7.75 to 7.85, was trading at 7.7504 per U.S. dollar on Tuesday afternoon, a few pips from the strong end of its trading band.

To be sure, bullish bets on the currency could become attractive from time to time in the second half of 2020, according to Becky Liu, head of China macro strategy at Standard Chartered Bank Ltd. Then, stock listings of Chinese companies in the city may drive demand for the Hong Kong dollar, potentially sending local interest rates higher.

But for now, Liu says, “The room for long-Hong Kong dollar arbitraging is getting smaller.”

©2020 Bloomberg L.P.