Sharp increases in U.S. interest rates have historically caused problems for emerging markets. During those times, people like me have wondered whether the Hong Kong dollar might be one of the casualties. For hedge funds or banks, the advantages of positioning for a break in the Hong Kong dollar’s peg to the U.S. dollar are partly that the payoffs are asymmetric and the cost to hold the position, unlike in just about any other emerging asset, is cheap. The reason for this is that the peg means implied volatilities (the estimate of how much the underlying currency will bang around over the life of the option) are very low.
Although those calling for Hong Kong dollar’s demise in the past have been wrong, it’s clear that the peg looks more fragile with every year that passes, and perhaps never more than at this moment. The currency is caught between the Scylla of rising U.S. inflation and interest rates and the Charybdis of a weakened China. The only question, really, is whether the Chinese government wants the hassle and expense of defending the Hong Kong dollar’s peg or whether it just bows to the inevitable. 1
Although those calling for Hong Kong dollar’s demise in the past have been wrong, it’s clear that the peg looks more fragile with every year that passes, and perhaps never more than at this moment. The currency is caught between the Scylla of rising U.S. inflation and interest rates and the Charybdis of a weakened China. The only question, really, is whether the Chinese government wants the hassle and expense of defending the Hong Kong dollar’s peg or whether it just bows to the inevitable. 1