Why tighter system liquidity must be expected among Hong Kong banks

Including steep correction in property prices.

According to CCB International, since the Fed’s hint of tapering last May, the investment community has accepted the commonly held belief that reduced asset purchases by the Fed in 2014 will inevitably lead to much higher interest rates. Going against conventional wisdom, the US 10-year yield has actually fallen below where it was when the Fed made its tapering announcement on 18 December 2013.

The question investors need to ask themselves is what happens if tapering does not actually lead to materially higher rates? While this goes against conventional wisdom, the price action in the Treasury market since the beginning of the year has shown that this is indeed occurring.

Here's more from CCB International:

We are of the view that in spite of tapering in 2014, the 10-year yield will end the year well short of the 3.40% consensus expects and that rates will surprise on the low side despite the unanimous call for higher rates.

Our reasoning is that (1) inflation remains subdued; (2) the US recovery is already in its late stages as suggested by the ISM being almost 1.5 standard deviations above average; (3) higher US mortgage rates created by fewer MBS purchases will provide a meaningful headwind to the housing-led US recovery; and (4) continued global uncertainty will underpin demand for Treasuries.

Implications for Hong Kong banks: Assuming higher US rates, conventional wisdom would dictate tighter system liquidity, a steep correction in property prices and materially higher loan provisions.

But given our view that rates will not rise much higher, a steep correction in property prices is unlikely given the correlation between rental and Treasury yields. As such, a spike in provisions will not materialize in the short-term. We say this even as we concede that margins may contract a bit. After all, it would be difficult for system liquidity not to tighten at the margin given how loose it has been the last 18 months.

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