Interest rate arbitrage at play noted amid spotlight on HKD peg

And HKD expectations likely shifting.

It has been noted that the spotlight is back on the HKD peg, and an analysis has stated that, to be clear, it has few doubts that the peg will continue to endure in the interim.

According to a research note from UBS, the HKD weakened to 7.82 against the USD last week and the 3M interbank rate (3M HIBOR) has edged up 30bps to 0.7% within two weeks.

The report said recent moves in rates and the currency largely reflect the bread-and-butter currency board mechanism at work and potentially some shift in expectations for the HKD to depreciate. They are consistent with UBS' thinking and further reinforce its cautious macro view on HK.

Here's more from UBS:

It has been a while since the last bout of outflows amidst the European debt crisis in 2011/12, the HKD touched the weak side of the HKD's narrow trading range (7.75-7.85). This, plus the jump in domestic interbank rates, surprised the market and fuelled questions on the peg's viability.

Interest rate arbitrage at work: Interest rate arbitrage is the essence of Hong Kong's currency board system. With the HKD fixed to the USD in a narrow range, an increase in US rates (relative to HK rates) should drive outflow from HKD to USD. When outflows occur, HKD weakens and HKD Hibor rises. When Hibor finally catches up with US rates in the process, interest rate arbitrage and thus outflows from HKD should then taper off. This is the market mechanism working to bring HK rates in line the US rates under the peg system.

Expectations on HKD likely shifting: Interest rate arbitrage aside, expectations for the HKD may have also shifted from appreciation to depreciation, in our view. Expectations for a de-peg, even if it does not eventually materialize, mean that HK rates will need to be above US rates to compensate for the perceived risks in holding the HKD.

What has fundamentally changed that could have caused the expectation shift on HKD? Continued depreciation in non-USD currencies, in particular the RMB since end-2015, is making strong HKD a more acute problem for Hong Kong. This, plus the deterioration in domestic macro fundamentals since 2H15, has likely started to fuel concern on HKD overvaluation.