Hong Kong Interest Rates – rational confusion
After peaking in early December 2022, HIBOR yields have subsequently plunged – triggering a record widening in HIBOR-LIBOR spreads and a rapid weakening of the Hong Kong Dollar (HKD). By mid-February, the HKD finally hit the weak side of convertibility, obliging the Hong Kong Monetary Authority (HKMA) to intervene in the foreign exchange markets for the first time in three months to defend the peg. Despite the central bank’s intervention, with several contemporaneous factors impacting Hong Kong money markets, interest rates spreads could remain volatile – with significant implications for HKD cash investors.
Capital flows and capital flight
Improving employment, sticky inflation and hawkish US Federal Reserve (Fed) comments have pushed US Libor rates higher – especially at the short end with 1-month now yielding 4.59%, the highest level in sixteen years. In contrast, after peaking in early December, HK HIBOR rates have tumbled (Fig 1a), with the 1-month plunging from a recent peak of 5.08% to a low of 2.12%. This has pushed the HIBOR-LIBOR spread to new record wide levels (Fig 1b).
Theoretically, Hong Kong’s Linked Exchange Rate System (LERS) should keep US and Hong Kong rates closely aligned, with any deviance quickly arbitraged. However, rapid Fed hikes in 2022 combined with a weak Hong Kong economy and excess local liquidity has caused the HKD to remain on the weak side of convertibility (HKD7.85) throughout most of 2022 (Fig 2a), only strengthening when the HKMA intervened to drain liquidity (Fig 2b), China announced its Covid policy pivot and the Fed slowed down the pace of rate hikes.
With the currency moving towards the strong side of convertibility, Hong Kong interest rates normalized towards 2022 year-end. However, strong investor inflows seeking to take advantage of China’s reopening pushed local rates lower with subsequent, additional pressure as investors started taking advantage of the carry trade - selling HKD, buying USD and locking in attractive yield pick-up.
By mid-February, the HKD hit the weak side of convertibility, triggering intervention by the HKMA for the first time in three months to support the currency. On Tuesday 14th of February, they purchased HKD4,228bn, followed by an additional HKD14,868bn on the 15th of February, reducing the aggregate balance to HKD77bn – the lowest level in almost three years. Foreign exchange, interest rate swaps and interest rates markets initially moved higher following the news; but the current carry trade pick-up suggests substantial further intervention will be necessary to reduce the HIBOR-LIBOR gap and move the currency back to the mid-point of its trading range.
Implications for HKD Investors
The swift and substantial drop in deposit and HIBOR rates has created a challenging investment environment for HKD cash investors. However, we believe the current period of abnormally low HKD interest rates (and wide HIBOR-LIBOR) spreads will only be temporary – with the potential for a sharp snap-back as further HKMA intervention occurs. HKD cash investors should consider maintaining a well-diversified ladder of investments with a focus on very short tenors to allow for rapid reinvestment at higher rates once local interest rate markets normalize.