Hong Kong money markets show investor calm is starting to crack

[HONG KONG] Cracks are starting to emerge in Hong Kong's currency and money markets, as traders speculate the local dollar's resilience to increasingly violent protests won't last.

Hong Kong stocks were already showing signs of stress, losing more than 5 per cent over the past week. Now, liquidity conditions in the foreign-exchange market are the tightest since the late 1990s, or the aftermath of the Asian financial crisis. Interbank rates are climbing - making funding costs more expensive for banks - while a gauge of expected swings in the Hong Kong dollar is near its highest in more than two months.

Analysts are debating whether the latest moves can be attributed to local unrest: cash supply was already under pressure due to seasonal needs from banks, as well as demand for Alibaba Group Holding's massive public offering. But this week's escalation in protests is reviving concern that the demonstrations could eventually lead to capital flight. Chinese President Xi Jinping said ending the violence was Hong Kong's "most urgent task."

While evidence of outflows has so far been mostly reassuring, a sustained flight could weaken the Hong Kong dollar, prompting authorities to defend the currency's peg to the greenback. That would mop up more liquidity and send borrowing costs even higher, affecting everything from mortgage rates to corporate funding.

The Hong Kong dollar's three-month forward points, an indicator of liquidity conditions in the foreign-exchange market, soared to the highest level since September 1999 this week. An increase in this gauge - resulting from a short-term drainage of cash - coupled with a weaker spot rate "signify an increase in risk-aversion to Hong Kong dollar assets," Chun Him Cheung, a strategist at Morgan Stanley, wrote in a note.

The three-month forward points climbed to 138, while the spot rate lost 0.03 per cent to 7.8295 per greenback as of 8:32am on Friday.

The three-month interbank borrowing costs of the Hong Kong dollar are 46 basis points higher than the equivalent interest rates on the greenback. That's the widest spread since October 1999, suggesting that financing is increasingly expensive for local lenders. On the other hand, the gap makes it costly for traders to short the city's currency.

Investors are also pricing in further tightness in the longer term. The cost of Hong Kong dollar 12-month interest-rate swaps, an indicator of traders' bets on future liquidity in the interbank market, jumped this month to the highest level in nearly a year.

The Hong Kong dollar's six-month implied volatility surged to the highest level since early September, suggesting traders are pricing in bigger swings in the currency. Its three-month risk reversal also rose to a two-month high, reflecting a jump in demand to short the currency with options.

Despite the cash squeeze, the Hong Kong dollar itself hasn't touched the weak end of its trading band against the greenback since May. Bolstering that resilience, according to OCBC Wing Hang Bank, is confidence that the city will remain a financial hub and what's perceived to be a lack of massive outflows - for now.

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