Hedge funds keep a toe in HKD carry trade despite rate rise

Hedge funds are continuing to run Hong Kong dollar carry trades despite a rise in local interest rates, albeit on a much-reduced scale compared with earlier in the year.

Dealers, however, expect a big resurgence in these positions should spot once again hit the bottom of the currency’s trading band, which would force authorities to intervene.

“We think the fast money [hedge funds] are still running some sort of long [US] dollar carry trade,” says a senior Hong Kong-based FX and rates trader at a large European bank. “But if we were running at 100% in April, which caused the big stop-loss to happen, I think they are only running around 20% this time, because the carry for long dollar is not as good as it used to be.”

John Luk, head of emerging markets trading at Crédit Agricole Corporate & Investment Bank, confirms Hong Kong dollar carry trade positions have not been completely unwound.

“There will still be carry trade positions in the market,” says Luk.

The carry strategy, which has been popular with hedge funds this year, involves monetising the USD and HKD interest rate differential under Hong Kong’s Linked Exchange Rate System, which maintains the rate within a narrow band of HK$7.75–7.85 to one US dollar. The currency has been highly volatile this year, bouncing between the two extremes of the range.

The gap between USD and HKD interest rates widened to more than 4% in June, after spot hit the 7.75 lower limit of the range and the Hong Kong Monetary Authority (HKMA) sold billions of Hong Kong dollars to defend the peg.

This collapsed the Hong Kong interbank offered rate (Hibor) and helped USD/HKD edge higher to the upper band of the peg. The interest rate differential led to a surge in interest in carry trades on the HKD once again.

The HKMA intervened again in August, selling USD for HKD to prevent the currency from breaching the 7.85 limit.

The withdrawal of HKD liquidity caused Hibor to rise once again, prompting funds to unwind a large chunk of their carry trade positions by selling USD for HKD.

Around 30% of the US$42 billion in long USD-versus-HKD positions were unwound in August, according to estimates by Barclays analysts.

That interest rate differential has now narrowed significantly. For instance, one-month Hibor had risen from 0.528% on June 20 to a high of 3.911% on September 23. As of October 2, the rate was 3.496%, while the US secured overnight financing rate (SOFR) 30-day average was 4.3%.

In one version of the carry trade, investors would sell HKD for USD using long-term forward contracts. For maturities of nine months or more, the forward rate is below 7.75, enabling investors to sell HKD at a more favourable rate than the spot market allows.

In another approach, investors use a tomorrow/next swap to sell their USD for HKD at the spot rate while agreeing to buy it back the next day. The profit comes from the forward points, an add-on to spot that accounts for the interest rate gap between the two currencies, as well as other factors such as supply and demand. Investors roll the trades daily so that the premiums accumulate into larger annualised profits.

As of October 6, spot USD/HKD was trading at 7.78, while tom/next forward points for the pair stood at  -1.5 pips, which annualises at more than 1%.

When the trade was at its height in the summer, the tom/next forward points were as much as  -28 pips a day as spot hovered near the very top of the band. Dealers say the majority of carry positions still in place are these tom/next forward trades.

At current levels, the most that spot can fall is 0.77%, meaning that hedge funds still earn a profit on the trade even at a 1% differential. And because trading USD/HKD spot and rolling tom/next forwards is typically done on a margin basis and consumes very little capital, it is still attractive even when interest rate differentials are tight.

“That’s the reason why even a 1% return is acceptable,” says the trader.

Smaller scale

Even though the rate gap between HKD and USD has narrowed, the FX and rates trader at the European bank says appetite for the trade remains.

“The market is still watching the Hong Kong dollar very closely, especially now that we are again close to the lower band,” the trader says. “If we do touch the lower band again, I think the market will be back in a decent way to run those carry trades again.”

One portfolio manager at a Singapore-based hedge fund tells Risk.net that the fund still holds HKD carry positions and plans to increase them if the currency touches the lower end of its trading band and HKMA intervention causes the interest rate gap to widen once more.

Crédit Agricole CIB’s Luk agrees, with the caveat that the trade is now “on a much smaller scale than when the interest gap is 2% or 3% wide”.

The FX and rates trader says the mark-to-market risks associated with longer-dated USD/HKD forwards are limiting the positions hedge funds are willing to take. The trades lose money on a mark-to-market basis if the outright rates for HKD strengthen, which was behind a run of stop-outs on the trade in May.

“If you’re working as a fast money account, I think the mark-to-market swings are also very important for them to manage,” says the trader. “That’s also one of the reasons why, while we think they still have some long dollar positions on, it is only 20% of what it used to be. It’s not an all-in moment for them, because the expected profit is quite thin.”

Luk adds that with liquidity conditions typically tighter in the fourth quarter, the risk-return profile of the trade perhaps looks less appealing than before.

“So, why not reduce the position a little bit? Which actually made a lot of sense,” he says.

Editing by Chris Davis, Joe Parsons and Lukas Becker