Historically, the Hong Kong dollar has not been worth putting on a trader’s radar. The currency trades between a narrow band of 7.75 to 7.85 HKD per U.S. dollar and the Hong Kong Monetary Authority has maintained the peg since 1983. Interest rates also are set to match the Fed. Before that, the Hong Kong dollar had pegs linked either to the British pound or U.S. dollar, but the value was readjusted periodically with economic conditions. As a result, the lack of movement in the Hong Kong dollar has made it not much different than holding U.S. dollars or trading U.S. dollar pairs.
That could be changing. With the diverging paths of the United States and emerging Asian economies, the peg might not be as stable as it has been for the past 30 years. Asian economies still are growing while the U.S. continues to stagnate economically.
To maintain the peg with the U.S. dollar while the Federal Reserve has held interest rates at 0% and printed trillions of dollars through quantitative easing programs, the Hong Kong Monetary Authority had to match the low rates even if they had adverse effects on inflation. A housing bubble and a high inflation rate of 3.8% (peaked at 7.9% in the summer of 2011) have been the byproducts of importing U.S. inflation. Because of pressure from a weakening U.S. dollar vs. Asian currencies, the Hong Kong Monetary Authority has needed to intervene to defend the peg since Oct. 20. Because of intervening on a regular basis with injections of more cheap money into the economy, inflation pressures have risen.
Will the peg hold?
When addressed with the concerns of higher inflation, the Hong Kong Monetary Authority reassures markets about its commitment to the U.S. dollar peg. However, recently it started to show opposition toward Fed policy. Defending the peg has devalued the Hong Kong dollar vs. the renminbi and other nearby Asian currencies. With 43% of imports coming from China, currency depreciation has resulted in inflation. Cheap money in Hong Kong also has driven “hot money” from mainland China to speculate in the real estate market and create bubble-like valuations in the housing market. Unless the Fed drastically changes course on interest rates, inflation in Hong Kong may reach the point where defending the peg may result in social unrest or other political pressure.
Despite financial turmoil in China and the recent strengthening of the U.S. dollar, Hong Kong dollar strength has been resilient. As seen in “Staying within bounds” (right), the Hong Kong dollar is still trading near highs and the limit of the peg vs. the U.S. dollar, even as risk-on currencies such as the Australian dollar and other Asian emerging market currencies around the world have crashed in value vs. the U.S. dollar. This strength is because of the stresses related to continued capital inflows into Hong Kong and persistent U.S. trade. imbalances with China and its international importers.
These monetary pressures make going long the Hong Kong dollar a trade with asymmetrical risk/reward potential. The most a trader would lose is 0.10 HK cents (1.29%) to the upper limit of the peg.
The reward potential on the other hand is much higher if the peg breaks. A reasonable price target for the Hong Kong dollar upon a broken peg is equal to parity of the Chinese renminbi (6.13/1 USD as of July 9, 2013). This would be 21% gain vs. the risk of a 1%, making the risk/reward raitio highly favorable for Hong Kong dollar buyers. If the peg shifts from the U.S. dollar to the Chinese renminbi, the appreciation of the renminbi is bullish for the newly pegged Hong Kong dollar.
The only major downside to this trade is that it will take patience. The peg can break down any day, but the inertia needed for a central bank to switch a 30-year-long policy will slow down this process. Leverage levels should be kept low to account for margin interest costs if readers decide to pursue this trade.
Nicholas Pardini is the founder and managing partner of investment firm Nomadic Capital Partners, which specializes in investing in emerging and frontier markets around the globe. His book, “The Definitive Guide to Emerging Market Currencies,” was written in response to his inability to find research on the subject. You can reach him at email@example.com.