Now May be the Time to Get into the Hong Kong Dollar

While the Yuan has continually increased in value against the US dollar, the HK dollar has done the exact opposite.  For eight out of the past nine months, the HK dollar has lost value, sending the USD/HKD currency pair into the upper half of the 7.75 to 7.85 trading band.  With the Hong Kong Monetary Authority capping gains and the ability to earn interest on long HK dollar, short US dollar trades this is an opportunity worth considering for traders and investors looking to go long Asia. 

However, before jumping into the trade it is important to understand the dynamics behind the recent weakness in the HK dollar. One of the main reasons is the possible intervention by the Hong Kong Monetary Authority.  In conjunction with the People's Bank of China, many traders believe that the region's central bank may be physically intervening in the market to prevent speculators from driving the currency higher and to allow the Yuan to exceed the HK dollar in value. 

China will begin to issue Renminbi denominated bonds in HK which should drive strong demand for the currency.  The central bank may be taking preemptive measures to temper any future increases.  The recent strength of the US dollar is also playing a major role in the currency's movement. Previously, with rates expected to be cut by the Federal Reserve, traders and global investors sought return in higher yielding economies in Asia and other emerging markets.  However, with fundamentals now improving in the world's largest economy, sentiment is also shifting. 

Market participants are expecting a stable 5.25 percent rate till the second half of the year in the US.  This change in ideals has prompted investors to readjust their portfolios leading to the outflow of capital from HK back into the US.

The outlook for Hong Kong however continues to remain strong since it is a major financial and manufacturing hub to the rest of Asia.  With ties to the US and Europe, the country has been the gateway for exports from both Taiwan and China.  This activity has increased employment to record highs as the economy sports an impressively low 4.4 percent unemployment rate.  Job prospects turn into higher wages, which has boosted spending and growth possibilities.  Ultimately, the pace of growth will help in supporting an appreciated currency as more and more interest is focused on investments that the country will offer.  The growth is in line with the accelerated pace of Mainland China. 

China, as an economic power, has sported consecutive rates of above 10 percent growth in the past several years. In 2006 alone, expansion accelerated at a 10.7 percent pace, almost 4 times that of the world's largest economy.  The notion has global investors clamoring for assets based in both countries, with billions already invested in real estate.  As China grows, HK will too since many local businesses cater to the residents in Mainland China.  In addition in the year ahead, more Chinese companies will go public on Shanghai and HK stock exchanges.  Foreign investors will be eager to participate, which will continue to fuel gains in the HK dollar.  

One of the most attractive aspects of this trade is the trading band itself.  The guaranteed limits of the 7.75-7.85 range provides a natural seller of USD/HKD at the 7.85 level.  Since May 18, 2005, the HKMA set the upper guaranteed limit of the HKD at 7.75 and the lower guaranteed limit at 7.85 in order to prevent against speculative bets on the Yuan through the HKD.  In maintaining the fixed exchange rate, policy makers need to offset any appreciation by purchasing more US dollar based assets and any depreciation by selling US dollars to contain the price action between the barriers of 7.7500-7.8500.  What this means is that if market speculation takes the HK dollar much lower, the monetary authority would need to step in to stem the currency's slide.      

There are two major risks to this trade.  The first would be if the HKMA does not honor the 7.85 limit.  This would not be a first for a central bank.  During the Asia crisis, many pegs were broken.  The same happened in the UK in 1992 when hedge fund manager George Soros broke the Bank of England by betting that they would not have what it takes to keep the British pound above the lower band of its Exchange Rate Mechanism. 

Hong Kong is unlikely to fall victim to the same attack however as China will probably step in to stem any major speculative driven slide.  With 1 trillion reserves under its belt, the People's Bank of China has more than what it takes to keep any currency supported.  The second more likely possibility is if HK enacts any foreign exchange controls and levies any taxes on foreign investment.  Many Asian nations have recently elected this method and if HK chooses to do so as well, it may cause a mass exodus out of HK dollars.  Even though the risk of either scenario is slim, they are worth noting.   

Kathy Lien is the Chief Currency Strategist at Forex Capital Markets. Kathy is responsible for providing research and analysis for DailyFX, including technical and fundamental research reports, market commentaries and trading strategies. A seasoned FX analyst and trader, prior to joining FXCM, Kathy was an Associate at JPMorgan Chase where she worked in Cross Markets and Foreign Exchange Trading.