Hong Kong is confronted with two gravity-defying puzzles this year. Investors are asking why the city’s interest rates are so low, and yet the housing market is so bad.
Because of its peg to the US dollar, the city’s borrowing costs should move in lockstep with those in the US. However, the gap between the one-month Hong Kong interbank offered rate, or Hibor, and the US secured overnight financing rate, or SOFR, has been widening to unprecedented levels since May, even as the Hong Kong Monetary Authority tightens liquidity.
It’s not supposed to be this way. Carry trades, whereby investors borrow Hong Kong dollars and sell them against the higher-yielding US counterpart, are able to close the rate gap. And this seemingly risk-free arbitrage would have been profitable for three months.
One explanation for the persistent rate differential is little appetite for the carry trade. There’s been talk for years that the central bank will break its peg. What if this prediction materializes? Gains from the arbitrage could be instantly wiped out if the HKMA allowed a wider trading band than the current 7.75 to 7.85 per dollar. Other Asian currencies, such as the Taiwan dollar, have rallied sharply this year.
It’s also possible that the HKMA is happy with the current Hibor level, and is hesitating to disrupt the status quo. Even though the central bank doesn’t officially have an interest-rate policy because of the peg, a slow and measured liquidity drain can nonetheless keep Hibor lower for longer. Meanwhile, it might be hoping that the Hong Kong dollar doesn’t hit 7.85 often, the weaker end of the trading range, as a rally in the Hang Seng Index continues to draw demand for the currency.
The HKMA doesn’t need to intervene if the Hong Kong dollar fluctuates within the narrow band. Its aggregate balance, which shrinks when it sells US dollars to pull the local currency from the weak end, stands at HK$64 billion ($8.2 billion), about 45% above the level at the beginning of the year.
The second, and related, puzzle has to do with residential real estate. Historically, there was a strong correlation with the stock market. That relationship has broken down lately. Home prices continue to struggle despite the Hang Seng’s bull run. The fact that housing has reached positive carry — it’s now cheaper to own than to rent, thanks to a much lower Hibor, which most mortgage rates are tied to — has not helped real estate to rebound, either.
Why hasn’t the wealth effect from the stock market kicked in? One possibility is that local residents have not fully participated, and thus benefited, from the rally. Stock purchases by Chinese investors through the stock connect account for as much as 30% of total turnover this year. Meanwhile, population inflow from Hong Kong’s successful Top Talent Pass Scheme hasn’t boosted local demand. Tight capital controls on the mainland prevent immigrants from bringing large sums of their money into Hong Kong.
As global markets toy with record highs, investors are baffled by some strange phenomena lately. In the US, tariffs are bringing in billions in revenue but no economic calamity. In China, a prolonged housing downturn has not triggered a Lehman moment, thereby allowing the government to practically sweep this big headache under the carpet.
So it’s perhaps no surprise that Hong Kong, a mature open economy whose capital markets are intertwined with the rest of the world, has some mysteries of its own. We are entering a known unknown territory.
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