The Hong Kong Monetary Authority (HKMA) has been actively supporting the Hong Kong dollar (HKD), purchasing 12.76 billion HKD. The total intervention has now reached 29.6 billion HKD. The HKD has recently hit its weak limit within the allowed trading range, prompting the HKMA to sell USD for HKD. Since 1983, the HKD has been pegged to the U.S. dollar, under the Linked Exchange Rate System, with a trading range of 7.75 to 7.85 HKD per U.S. dollar.

How the Currency Board System Works

The HKMA uses an automatic adjustment mechanism to keep the HKD within this band. Their Currency Board System ensures that every HKD is backed by U.S. dollar reserves at a fixed rate, linking changes in the monetary base to foreign exchange movements. When the HKD approaches the strong side at 7.75, the HKMA sells HKD and buys U.S. dollars, which adds liquidity. On the other hand, when the HKD nears 7.85, the HKMA buys HKD and sells U.S. dollars, which removes liquidity. This process helps maintain exchange rate stability within the trading range. So far, we are seeing a classic example of the Currency Board principle in action. The HKMA is keeping the peg intact by buying local currency as demand for dollars rises. Each time the HKMA purchases HKD, they effectively tighten liquidity conditions, pushing overnight rates up and making it more expensive to short the currency. This is exactly what the system is meant to do, anchoring expectations without relying on discretionary policies. The recent interventions, totaling nearly 30 billion HKD, highlight the continuous capital outflows or positioning pressures that push the exchange rate towards the 7.85 limit. This usually indicates interest rate differences with the U.S. or a greater demand for higher-yielding dollar assets. Regardless, the system remains stable. Each HKD in circulation is backed, and there’s little reason to doubt the peg as long as those reserves remain strong.

Effects of the Peg Mechanics

In the short term, we can expect more movement in both rates and currencies. Funding costs in Hong Kong are likely to rise. This increase won’t be drastic but will be noticeably tighter compared to recent months. The changes in overnight interbank rates caused by HKMA actions will influence the broader interest rate landscape. We should also anticipate higher implied volatilities. Short-dated swap points are likely to see more activity, especially those tied to near-term rate expectations. This could lead to shifts in forward FX rates, reflecting a higher HKD funding value and expectations of further defensive actions by the central bank. Derivatives linked to the short end, particularly those sensitive to overnight or one-month rates, may become less predictable. In our experience, this type of tightening can catch pricing models off guard, especially if they rely too much on stability assumptions. There’s a common tendency to underestimate how quickly local liquidity can tighten once the 7.85 level is approached, but the frequency of intervention suggests a growing pattern. What we’ve observed isn’t an isolated incident. The takeaway is that those with currency positions should be cautious about using leverage. Overnight spikes in local funding costs can create slippage, particularly for carry-sensitive positions. Furthermore, pressure at the top of the band might persist for weeks, especially if U.S. interest rates stay the same or rise. As the peg remains stable, fluctuations may shift from spot rate volatility to changes in swap spreads and interest rate differences. It’s important to monitor the total issuance of Exchange Fund Bills, as this is one of the HKMA’s preferred tools for managing liquidity. Increased issuance usually accompanies FX interventions and shouldn’t be evaluated in isolation. Yields across different timeframes may not move together—shorter maturities might respond more quickly to FX interventions. This could lead to curve flattening in local terms. While not the entire curve will adjust at once, it raises the question of whether holding short versus long positions is less appealing from a carry perspective. We believe short-end activity will remain reactive, driven heavily by expectations of whether further dollar purchases are needed. Keep an eye on the tightness toward the end of the quarter. Any pressure on three-month paper might indicate wider funding concerns, though it’s too soon to make any definitive calls. For strategies relying on low volatility or tight spreads in the local market, consider the potential noise from ongoing interventions. We may see slight disruptions in short-end instruments. While these disturbances won’t be constant, they are likely to appear often enough to affect positions that are finely tuned or closely correlated with U.S. rate movements. Broader risk sentiment is not irrelevant, but for now, the mechanics of the peg are functioning as intended. We believe expectations should shift toward slightly firmer funding conditions and increased price movements in front-end derivatives. This includes FX forwards, short-term swaps, and the base rates that support them. Each defensive move tends to tighten conditions a bit more. Recent weeks clearly demonstrate this trend, and we can likely expect more such actions in the future. Create your live VT Markets account and start trading now.

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