<p>The infamous Hong Kong Foot is a slang for smelly Athlete’s Foot. Similarly, a Hong Kong Foot-equivalent could happen where a rally in HKD creates a stench via an asset market correction.</p><p>An ongoing HKD carry trade has unfolded with the HKD weakening by 95 bps for the past two years. The HKD has briefly touched 7.85, near the weak band of the currency peg of 7.75 - 7.85. This could led to intervention from HKMA and negatively impact the asset markets. We discuss three thoughts on the weak HKD.</p><p><b><span style="text-decoration: underline;">HKD carry trade</span></b></p><p>Flush liquidity has resulted in a HKD carry trade where investors borrow in HKD and invest in higher yielding USD. The 3m HIBOR is hovering at 1.18%. Despite the 40bps rise in 3m HIBOR, it has lag behind the almost 100 bps climb in 3m LIBOR. The unrelenting rise in 3m LIBOR has resulted in the spread between both of them to be more than 110 bps, near its decade-high. The wide spread has resulted in an attractive carry trade for HKD borrowers and pushed HKD to its decade low.</p><p><b><span style="text-decoration: underline;">Debt binge</span></b></p><p>The Hong Kong market is flushed with liquidity from the flood of money from China. This is driven by the Shanghai-Hong Kong Stock Connect with significant investment flows from China to Hong Kong. Chinese companies have loaded up on HKD debt to fund outbound purchases, resulting in greater leverage and higher asset purchases. The abundance in liquidity pushed the funding costs in Hong Kong low and boosted housing and equity prices to record highs in Hong Kong.</p><p><b><span style="text-decoration: underline;">Unwinding HKD carry trade could stink</span></b></p><p>The HKD has weakened by about 95 bps for the past<b> </b>two years. At the 7.85 end, the Hong Kong Monetary Authority (HKMA) is obligated to defend the peg by buying HKD since it is at the end of the 7.75 -7.85 peg. This means draining the liquidity and allowing 3m HIBOR to go higher. A spike in HIBOR will reduce the affordability in the housing market especially investors on HIBOR-linked mortgages. Further, tightening monetary conditions are negative for the Hong Kong equities market with the withdrawal of ultra-cheap money.</p><p>A spike in HKD could disrupt the Hong Kong asset markets and trigger a risk-off environment for other markets. Markets have been choppy of late in the light of rising trade tension between the US and China. A correction in the Hong Kong equities will worsen matters. The unwinding of HKD carry trade could really stink!</p><p><b>Edmund Chan, CFA</b></p>