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The prospect of higher interest rates is lighting a fire under the Hong Kong dollar

Kelly Olsen

A period of weakness for the Hong Kong dollar appears to be coming to an end, and that has investors watching.

The Hong Kong dollar is only allowed to trade between HK$7.75 and HK$7.85 to its U.S. counterpart and has been languishing at the weak extreme of its range for much of 2018. But on Friday it recorded its biggest one-day increase in 15 years to as strong as about HK$7.79. Although it's given some of those gains back — trading Wednesday around HK$7.81 per U.S. dollar — it's still markedly stronger than it had been.

Despite the relatively small size of Hong Kong's overall economy its currency punches far above its weight: It was the world's 13th most traded by value, according to a 2016 Bank for International Settlements report. And while its exchange rate is limited to a narrow band against the U.S. dollar, fluctuations can reveal brewing changes in the local economy.

Hong Kong has been a special administrative region of China since the end of British colonial rule in 1997, and its currency has stood as a symbol of the city's economic autonomy. Beyond that, it's also a significant indicator for regional investors.

The strength of the Hong Kong dollar has a "pretty high correlation" with the stock market, Jackson Wong, associate director at Huarong International Financial Holdings, told CNBC on Wednesday.

"When you look at history, when the Hong Kong dollar was strong the market usually performed better," he said, adding that a strengthening local currency signals increasing capital inflows into the economy.

That could be good news for Hong Kong, where the Hang Seng Index has declined about 7 percent so far this year.


Interest rates

The Hong Kong Monetary Authority, the de facto central bank, defends the exchange rate band by controlling the amount of Hong Kong dollars in circulation. Its stash of foreign exchange reserves, which stood at $424.9 billion at the end of August, provides authorities with a potent arsenal for buying up bills.

Because of the link, the HKMA automatically raises the city's policy interest rate to match hikes by the U.S. Federal Reserve . The Fed has been increasing its key rate since 2015 and is expected to carry out another hike at a policy meeting later Wednesday.

Hong Kong's commercial banks, however, have held back, though pressure is mounting.

Wednesday's expected Fed increase "could be the trigger for HK banks to raise the prime rate for the first time since 2006," Citi said in a note Tuesday, predicting a move as early as this week.

"A hike is likely to increase the interest expenses of mortgage borrowers," Citi said, adding that Hong Kong banks will in the near term likely "suffer slower loan growth."

Analysts have been forecasting declines in the city's notoriously expensive property market , with CLSA being the boldest with a prediction last month of a 15 percent fall in prices within 12 months.

Some investors have taken advantage of the weakness in Hong Kong rates to use the Hong Kong dollar's relative cheapness as a funding currency to invest in higher yielding assets elsewhere, though that may be coming to an end.

"Speculators saw the opportunity to short the Hong Kong dollar and take advantage of that dislocation," Mark Konyn, chief investment officer at AIA Group in Hong Kong, said, referring to the interest rate differential.

"And I think that's played out probably longer than people expected and it's certainly been profitable for those that have done it," he said.