Hong Kong dollar outlook bearish despite big rally

Rushil Dutta

Sept 14 (Reuters) - The Hong Kong dollar has retreated from

its sharp rally last week triggered by the yuan’s rise and broad

weakness in the U.S. dollar, but analysts expect low interest

rates will keep the currency on the weaker side of its narrow

trading band.

The Hong Kong dollar spot rate was marginally firmer

against the dollar at 7.8116 by 0758 GMT on Thursday, and

is on track to finish the week slightly higher, preserving all

of its gains from last week.

The pegged currency rallied sharply and unexpectedly against

the dollar on Friday, when it tore through the crucial 7.8 level

to the higher side of its 7.75 to 7.85 currency band after

steadily depreciating against the dollar all of this year.

It rallied 0.17 percent over Wednesday to Friday last week,

after having declined about 0.9 percent in previous eight

months.

Analysts said they expected the Hong Kong dollar to remain

weak, primarily because of a widening interest rate differential

as the Federal Reserve progresses with rate rises.

It has raised rates twice this year and is expected to

reveal next week its plans for unwinding massive fiscal stimulus

introduced after the financial crisis.

“It (the U.S. dollar-HK dollar value) still should go higher

because of the onshore rates are still very low, relative to the

U.S. rates," said Andy Ji, currency strategist at Commonwealth

Bank of Australia.

"It doesn't matter how gradually the U.S. is tightening

monetary policy. For Hong Kong, liquidity is too flush. There is

no way it can soak up enough liquidity, so that's the main

driver for the Hong Kong dollar,” Ji added.

The sum of balances maintained by commercial banks with the

Hong Kong Monetary Authority (HKMA), also called the 'aggregate

balance', was HK$227.54 billion ($29.13 billion) as of

Wednesday's close, a notable drop from end-August.

It had beene as high as HK$426.34 billion in late 2015, but

has been steady around the HK$260 billion level in the past 12

months.

HIBOR-LIBOR spreads, the differential between floating rates

at which banks lend to each other in Hong Kong and the U.S.

respectively, have been gradually widening since 2015, and the

3-month spread is now 0.56536 versus -0.02878 basis points at

the beginning of this year.

“Last week’s rally happened mainly because of the European

Central Bank meeting a day before -- no one knew what would

happen, everyone was long euro. Also, there was the North Korea

threat,” a trader said.

“The market was long U.S. dollar against the Hong Kong

dollar. If North Korea launched a missile over the weekend, the

dollar could further fall. So the market unwound its previous

dollar position.”

At the end of last week, the dollar was at its weakest in

more than 2-1/2 years against a basket of major currencies as

the euro jumped after a Reuters report showed that ECB

policymakers were in broad agreement that their potential next

step would be to reduce their bond purchases.

Dollar bearishness was exacerbated by fears North Korea may

test fire another missile over the weekend, Hurricane Irma

sweeping the western coast of the United States of America, and

reduced expectations of another rate hike by the U.S. Federal

reserve this year.

Broad dollar weakness forced the unwinding of long dollar

positions across currencies, with the yuan blowing

past the 6.5 per dollar level.

The yuan's rally onshore was echoed by sharp gains in the

offshore yuan -- which touched its highest since March

16 -- and the Hong Kong dollar.

“The sensitivity of the USD-HKD to the USD-CNY picked up as

the latter broke the 6.5 level,” said Wee Choon Teo, FX

strategist, Asia ex-Japan, at Nomura.

Analysts believe widening spreads and ample cash in the Hong

Kong dollar market, compounded by a central bank constrained by

policy choices, will keep the currency mired in the weaker end

of the trading band.

But the currency is still far from levels that would spur

any intervention by the HKMA, analysts said.

“They (HKMA) are not in a market to influence the interest

rates. So, any intervention in terms of liquidity withdrawal is

going to be very minimal. That is until it hits the top of the

band and they are forced to intervene. Till then they just wait

and watch and hope the U.S. doesn't raise rates faster than

expected,” said Ji.

Most market participants do not expect the HKMA to intervene

unless the Hong Kong dollar falls to the lower end of the

trading band, forcing the de facto central bank to start selling

dollars and withdraw Hong Kong dollar liquidity.

($1 = 7.8118 Hong Kong dollars)

(Reporting By Rushil Dutta in Bengaluru; Editing by Kim

Coghill)