Long Hong Kong Dollar: Breaking Of Peg Provides Asymmetrical Payouts

Includes: EWH
by: Nicholas Pardini

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 USD and has maintain the peg since 1983. Interest rates are also set to match the Fed. Before that, the Hong Kong dollar had pegs linked either to the British Pound or US dollar, but the value was periodically readjusted with economic conditions. As a result, the lack of movement in the Hong Kong dollar has made it not much different than holding US dollars or trading USD pairs.

However, with the diverging paths of the US and emerging Asian economies, the peg might not be as stable as it has been for the past thirty years. Asian economies are still growing while the US continues to stagnate economically. The Federal Reserve's holding of interest rates at zero percent and printing trillions of dollars through quantitative easing programs, and in order to maintain the peg, the Hong Kong monetary authorities have to match the low rates even if they have 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 US inflation. Due to pressure from a weakening US dollar versus Asian currencies, the Hong Kong authority has needed to intervene to defend the peg since October 20th. Due to intervening on regular basis with injections of more cheap money into the economy, inflation pressures have risen.

When addressed with the concerns of higher inflation, the Hong Kong monetary authority reassures markets about its commitment to the US dollar peg. However, recently the Hong Kong monetary authorities are starting to show opposition towards Fed policy. Defending the peg has devalued the Hong Kong dollar versus 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 has also driven "hot money" from Mainland China to speculate in the real estate market and create bubble like valuations in the housing market. Unless if the Fed drastically changes course, inflation may get to the point where defending the peg may result in social unrest or other political pressure.

These monetary pressures make going long the Hong Kong dollar a trade with asymmetrical risk/reward potential. The most a trader would lose 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. If the peg shifts from the US dollar to the Chinese renminbi, the appreciation of the renminbi is bullish for the newly pegged Hong Kong dollar.

The only downside to this trade is that it will take a lot of patience. The peg can break down any day, but the inertia involved 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.

The Hong Kong dollar can be traded directly on many major US brokers, both in spot and futures form. For those who do not trade currency directly, the best indirect trade the breaking of the Hong Kong dollar peg is through the Hong Kong iShares ETF (NYSEARCA:EWH), as a rising currency will pull up stocks in dollar terms. However, the risk in trading this through the equity market is a Chinese hard landing related pullback.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. am long Hong Kong Dollar currency directly. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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