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Hong Kong dollar's selloff risks kneecapping the city's equities

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The Federal Reserve is playing havoc with the Hong Kong dollar - and the stock market could be next.

[HONG KONG] The Federal Reserve is playing havoc with the Hong Kong dollar - and the stock market could be next.

The pegged currency has been torpedoed this year, sliding to a 15-month low versus the greenback as a mortgage war deters local banks from tightening along with the Fed. As the interest-rate differential with the US widens, strategists are tipping further losses, and equity investors are taking note.

The Hong Kong dollar is within 0.2 per cent of HK$7.80 per US dollar, a level that could trigger outflows from the stock market, according to Ample Capital Ltd. and Core-Pacific Yamaichi.

Their theory? Traders start ditching rate-sensitive equities on concern the weakness will spur officials to start buying the currency to shore up the peg, thereby boosting borrowing costs.

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"7.80 would be the psychological level to have some impact on Hong Kong stocks," Alex Wong, a director of asset management at Ample Capital, which oversees about US$120 million. That level - which currency strategists expect to be reached mid-year - would be a signal that short-term Hong Kong dollar interest rates may be poised to increase.

"People would not be comfortable," Mr Wong said.

The Hang Seng Index traditionally moves in tandem with the city's currency, falling when the Hong Kong dollar moves toward the weak end of its HK$7.75 to HK$7.85 per dollar trading band, as it did at the start of 2016.

Demand for Hong Kong shares as buyers flee a selloff in mainland China has helped dilute that relationship, however, with the Hang Seng rallying to its highest point since July 2015. Property stocks - likely the most vulnerable to an uptick in concern about rising rates - have driven this year's 14 per cent advance.

Hong Kong has been tightening: the city's de facto central bank boosted its base rate twice since the start of December, tracking the Fed because of the demands of the peg, which was put in place 34 years ago to stymie capital outflows in the lead up to the territory's return to Chinese rule. But local lenders' reluctance to pass that increase on has seen the premium on Libor - the one-month US interbank rate - over Hong Kong's Hibor rate swell to more than 61 basis points, the most since December 2008.

There's a higher chance of the Hong Kong dollar reaching the weak end of the trading band, Goldman Sachs analysts said in a note earlier this month. Once the currency gets to HK$7.85, the Hong Kong Monetary Authority is obligated to step in and support it.

HK$7.80 is the midpoint of that range, and dropping to that level would unleash expectations for intervention, fueling risk aversion in equities, said Castor Pang, head of research at the investment bank Core-Pacific Yamaichi in Hong Kong.

"The chance of a US interest-rate hike in June looks high, which is likely to further drive funds out of Hong Kong dollars and in to dollars - seeking higher returns," he said.

The Hong Kong dollar is also on other stock watchers' radars: Andrew Clarke, director of trading at Mirabaud Asia Ltd in Hong Kong said the currency moving out of the HK$7.755 to HK$7.77 range that it spent most of 2016 within is unnerving investors.

While the reasons behind this bout of Hong Kong dollar weakness are different to the start of last year, when it spiked weaker as gyrations in Chinese markets whipsawed global investors, this decline will still put pressure on equities, he said. There will be less demand for the currency in anticipation of rate increases, which weighs on stocks, bonds and property as people repatriate funds back into US dollars for the higher returns.

Tommy Ong, managing director for Treasury and markets at DBS Hong Kong Ltd says there's not enough loan demand in Hong Kong to provide support for the currency.

The Hong Kong dollar may weaken to HK$7.80 some time before mid-June if the interest rate differential widens to one per cent, Mr Ong said. Pressure on the stock market will be temporary as sentiment will be supported by gains in global equity markets, especially those in the US which are rising on expectations for fiscal stimulus.

Stephen Innes, a senior currency trader at Oanda Corp isn't overly worried, though.

The Hong Kong dollar will probably weaken further as markets price in Fed rate hikes, but the downside will be limited at HK$7.8, he said.  Interest rate differentials are likely to narrow as there was a gradual normalisation on that front when US policy makers started to move rates previously.

Philip Li, a senior fund manager at Value Partners Ltd, whose parent oversees about US$14.5 billion of investments, doesn't see the currency hitting HK$7.85.

Hong Kong dollar weakness is caused by the US dollar's gains on the back of tightening monetary policy and improvement in US economic fundamentals, Mr Li said. That retreat may be tempered after the Fed hikes rates again.

There's unlikely to be a panic in equity markets. Inflows of capital from China are helping buoy liquidity in Hong Kong, which is keeping a lid on rates, he said.

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