The Hong Kong Monetary Authority (HKMA) is the central bank of Hong Kong and is buying Hong Kong dollars (HKD) to support the currency. This action is needed because the HKD has reached the top of its trading band, amidst a strong U.S. dollar (USD) and a weak HKD. Since 1983, Hong Kong’s currency policy has pegged the HKD to the USD through the Linked Exchange Rate System (LERS). This system keeps the HKD trading around 7.80 per USD, within a range of 7.75 to 7.85.

Currency Board System

The HKMA uses an automatic mechanism to maintain this band. They have a Currency Board System, where every HKD issued is backed by U.S. dollar reserves at a fixed rate, linking the monetary base to foreign exchange flows. When the HKD gets close to 7.75, the HKMA sells HKD and buys USD to increase liquidity. When it approaches 7.85, they buy HKD and sell USD, reducing liquidity. This process helps keep the HKD stable within its trading limits. The HKMA’s actions show a clear monetary policy to protect the currency peg. With the HKD pushing towards the weaker end at 7.85, there is increased selling pressure. By buying HKD and selling USD reserves, the HKMA is taking HKD out of circulation. This decreases the available liquidity of HKD, making it less likely to weaken further. This peg has worked for over forty years because it is automatic and widely trusted. It helps remove uncertainty around exchange rates, making cross-border business planning easier. However, historical trends indicate that strong pressures on either side of the band usually happen when interest rates are moving apart. This is what we are seeing now, as U.S. rates remain high while Hong Kong follows U.S. monetary policy, despite different conditions at home.

Aggregate Balance and Market Implications

We can track this situation by looking at the Aggregate Balance, which shows the liquidity in the interbank market. The more the HKMA sells USD and buys HKD, the smaller this balance becomes, indicating tighter funding conditions. Market players using forward rates or assessing future liquidity should closely monitor these actions. During past interventions, prices in derivatives, especially in FX and interest rates, often adjust in anticipation of higher local funding costs. We should also consider the impact on carry trades and short-term interest rate hedges. Current trends indicate that further interventions may be required if negative sentiment about the HKD continues, which could temporarily affect implied volatility or pricing. Short-term markets usually respond quickly, so any changes here might signal future trends. Yuen has previously stated that the peg is strong and reliable. His focus on the operational mechanism is a reminder; the HKMA is not just reassuring but actively using this system. Frequent transactions indicate that they are countering speculative positions directly. Keep an eye on swap market demand and any irregularities in forwards. Changes in USD/HKD forwards, especially those that diverge from covered interest parity, can reveal funding pressures or market imbalances. Watching how these spreads shift in the coming days could provide important insights. Volatility in one-month implied rates has already begun to increase since last week. For positioning, changes may be needed if there are assumptions of low liquidity. Swaptions and FX options with shorter timeframes may start reflecting the chances of more reactive rate conditions. If the Aggregate Balance continues to decline, some hedging strategies involving rate caps or collars may need adjustment. The technical peg itself is not a prediction; it’s a stable point maintained by a functioning system. However, this system creates liquidity challenges when activated. As this situation unfolds, we are reconsidering the cost of short-term positions in HKD-related instruments. Create your live VT Markets account and start trading now.

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