Hong Kong Dollar’s Slide to Two-Year Low Is About to Get Worse

(Bloomberg) -- The Hong Kong dollar is poised for steeper losses as impending Federal Reserve rate hikes exacerbate capital outflows triggered by the deadliest Covid outbreak in the city.

The currency extended its drop to the lowest in more than two years this week and option-implied volatility indicates a 32% probability that it could fall to the weak end of its 7.75-7.85 per dollar trading band by the end of the second quarter. 

BofA Securities Inc. and Daiwa Capital Markets Hong Kong Ltd. are among those betting on Hong Kong's currency falling to 7.85 this year as Fed hikes reduce the attractiveness of the city's assets. To make matters worse the government's efforts to stamp out Covid are pushing the economy back into contraction this quarter.

“It may only take weeks to hit the 7.85 level after the Fed hike,” said Kevin Lai, chief economist for Asia ex-Japan at Daiwa Capital Markets, adding that “the biggest shake-up is yet to happen.” 

The city imports U.S. monetary policies due to a linked exchange rate with the greenback. However, funding costs in Hong Kong remain low as liquidity in the banking system stays ample, while interest rates are set to rise in the U.S., which is expected to hurt the appeal of the city's assets.

Last month, the gap between the three-month interbank rate on the Hong Kong dollar -- known as Hibor -- and the funding cost on the greenback expanded to the largest since 2019. One-year Hong Kong dollar forwards have also slumped this year, suggesting yields on the currency have been falling versus the greenback. 

Domestic Doldrums

The combination of tightened social restrictions locally and higher interest rates in the U.S. could lead to weaker loan growth and home prices, Bofa Securities strategist Chun Him Cheung wrote in a note, adding that the Hong Kong's currency may slump to the weaker end of its trading band by the fourth quarter. The Hong Kong dollar was little changed at 7.81 per greenback as of 3:46 p.m. local time.

Hong Kong is facing its worst virus outbreak to date as cases explode and deaths tick higher. Talks on a city-wide lockdown and plans for mass-testing the city's 7.5 million inhabitants for Covid have led to thousands of residents fleeing the city. 

READ: Hong Kong Braces For Lockdown as Daily Cases to Breach 50,000

Bearish bets against Hong Kong shares have climbed to records and the benchmark Hang Seng Index is near a two-year low. The Hong Kong dollar has fallen to the lowest in nearly four years against the offshore yuan in another sign of weakening confidence in the city as residents ramped up deposits in the Chinese currency by the most since 2010 in January.

With authorities showing no appetite for a living-with-Covid strategy, combined with a more aggressive Fed tightening schedule, both factors could push the former British colony back into a recession, said Daiwa's Lai. “Outflows are likely to be much bigger in the current cycle,” he said.

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