Hong Kong's HIBOR slide and a post-Liberation Day revival of the carry trade

Hong Kong's key interbank lending rate tumbled in the wake of Donald Trump's "Liberation Day" tariffs. This phenomenon — a result of the Hong Kong dollar's peg to its US counterpart, and capital rushing into Asian economies amid the greenback's weakness — has resulted in a revived carry trade. Investors can borrow cheaply in one currency to invest in riskier, higher-yielding assets elsewhere.

Since May, the Hong Kong Interbank Offered Rates — the rate at which banks lend to each other in HKD — have dropped sharply to less than 1%. That's created an unprecedented differential against HIBOR's US counterpart, the Secured Overnight Financing Rate, or SOFR. The one-month spread has sometimes reached 400 basis points.

After Trump's tariff announcement in April, Asian currencies rapidly appreciated. This influx of capital spilled over into Hong Kong at a time when the city's capital markets were seeing demand for liquidity, driven by local IPOs. The Hong Kong dollar rapidly strengthened to the top of its trading band with the USD, meaning the Hong Kong Monetary Authority (HKMA) injected liquidity into the HKD market by maintaining this currency peg -- selling HKD for USD.

As a result, the aggregate balance (a key indicator of interbank liquidity in Hong Kong) quadrupled within a few days. That sent HIBOR sharply lower. (This phenomenon shows how monetary policy operates in Hong Kong's currency board system, where the HKMA does not conduct monetary policy by raising or lowering a key interest rate.)

The popularity of the carry trade, in turn, pushes the HKD to the opposite end of its trading band.

We can examine this phenomenon from another angle using fund-flow data from EPFR. As our third chart shows, since May, Hong Kong has seen an exceptional inflow into locally based money-market funds -- which are profiting from this HIBOR differential with the US.

Meanwhile, low borrowing costs in HKD and abundant liquidity are supporting a local equity rally. Our fourth chart shows past episodes where low HIBOR has coincided with a rally in the Hang Seng.

Finally, we look at Southbound Stock Connect, which interlinks the Shanghai, Shenzhen and Hong Kong exchanges. Flows have remained strong, helping fuel that stock market momentum amid a strong IPO pipeline.

As our scatter chart shows, "southbound" net flows to the Hong Kong stock exchange have recently exhibited a strong positive correlation with the HKD trade-weighted nominal effective exchange rate — underscoring their increasingly significant role in supporting HKD demand.

Looking ahead, HIBOR is expected to gradually rise and normalize. However, the magnitude, pace and timing of HKMA's liquidity withdrawal and ultimate interest rate convergence with US rates remain uncertain, with key variables including future US policy, trade uncertainty, and broader investor sentiment.

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