Hong Kong dollar pressured as local yields tumble

* HKD could hit 7.85 per dollar band within weeks

* Hong Kong rates lag U.S. most since financial crisis

* Softer Chinese economy, dovish Fed the main culprits

By Noah Sin

HONG KONG, Feb 1(Reuters) - Excess cash in Hong Kong's banking system has caused the local dollar to weaken so far in 2019, and traders expect the pegged currency will soon test the lower end of its tight band against the U.S. dollar.

The Hong Kong dollar has fallen more than half a percent since early December, when it was trading close to the middle of its 7.75-7.85 band against the U.S. dollar. It was quoted at 7.8456 on Friday

Analysts say that decline is being driven by falling local interest rates.

One-month inter-bank rates(HIBOR) have fallen 139 basis points since mid-December, mimicking a drop in U.S. yields as expectations rose for the Federal Reserve to slow its pace of monetary tightening.

That caused spreads between Hong Kong and U.S. yields to widen, with the one-month rate 1.49 percentage points below dollar rates on Wednesday, the widest since January 2008.

The widening spread led investors to borrow the Hong Kong dollars cheaply and use that to buy higher-yielding U.S. dollar assets in a carry trade, spurring capital outflows and pressure on the local currency.

The currency is in danger of breaching the top end of its 7.75-7.85 range in the first quarter, said Cliff Tan, Hong Kong-based East Asian head of global markets research at MUFG.

With the Fed hinting this week at a pause to further rate hikes, "there will be nothing but red meat for this kind of trade,” said Tan.

Such carry trades had become unviable in the second half of 2019 as rising U.S. yields and demand in Hong Kong for new share issues caused HIBOR to rise.

But Hong Kong rates slumped again early in 2019 on weaker loan demand "due to China’s easing policy and concerns about economic outlook,” Tommy Xie, an economist at OCBC in Singapore, said in a note this week.

China's economy grew at its slowest pace in 28 years in 2018 and is expected to cool further this year, pressured by sluggish domestic demand and disruptions in its supply chains as the Sino-U.S. trade war escalated.

Hong Kong’s retail sales grew at the slowest in 18 months last December.

FALLING BEHIND

The Hong Kong Monetary Authority would be obliged to buy the local dollar if it hits the weak end of the band.

Hong Kong's base rate moves in lockstep with that of the United States as part of its commitment to a currency peg. But commercial lending rates are determined by banks and widely-watched in the city, one of the most expensive housing markets in the world.

With ample capital chasing deposits, as represented by the HK$76.2 billion ($9.71 billion) aggregate balance, “banks don’t have incentives to raise rates" at this point, said Ivy Wong, managing director at Centaline Mortgage Broker in Hong Kong.

Local banks lifted benchmark lending rates for the first time in 12 years last September, but refrained from following the Fed in hiking again in December.

One-month HIBOR was 1.01 percent on Friday, while three-month HIBOR stood at 1.72 percent.

($1 = 7.8456 Hong Kong dollars) (Editing by Vidya Ranganathan and Kim Coghill)