© Reuters.

(Bloomberg) — Fears that capital could flee Hong Kong are visible just about everywhere in the currency market, testing the local dollar’s resilience to economic recession.

Speculators are all-in betting on significant depreciation with derivatives, sending a measure of bearishness to near its highest level of the year. Volume on Hong Kong dollar options soared to $3.7 billion on Friday, with a third of the trades betting the pegged currency would hit or break the weak end of its trading band.

Conviction that turbulence will get worse is also evident in the swaps market, where the spread between local and U.S. rates reached levels last seen in the 1990s. One-year forward points closed at the highest since 1999, suggesting a spike in demand to hedge against depreciation in the currency.

Hong Kong is the epicenter of escalating U.S.-China tensions following Beijing’s shock decision last week to impose a law to curb dissent in the city. That stoked the Hong Kong dollar’s biggest drop in six weeks and the worst stock rout since 2008. The Trump administration is considering responses that could include revoking Hong Kong’s special trade status, a risk that threatens to undermine the city’s standing as a global financial hub.

The sudden bearishness is crashing against the city’s elevated borrowing costs, which have kept the long Hong Kong dollar carry trade profitable since November. Liquidity in the financial system remains relatively tight for now, keeping the city’s interbank rates wide versus those in the U.S. Plans from some of China’s biggest companies to sell shares in Hong Kong in June should make that more pronounced by increasing the demand for cash.

The key question is how the Hong Kong dollar’s yield advantage over the greenback can act as a support for the currency.

“Some capital inflows chasing new listings in the city could offset some fund outflows this quarter,” said Ken Cheung, chief Asian currency strategist at Mizuho Bank Ltd. “However, the main risk is how the U.S. will deal with Hong Kong’s special status.”

The Hong Kong dollar’s recent strength was upended last week as China confirmed it would effectively bypass the city’s legislature to implement its controversial national security laws, which critics say will erode freedoms of speech, assembly and the press. The currency had traded near the strong side of its narrow band since April largely thanks to a popular trade where hedge funds sold the greenback for the city’s higher-yielding dollars.

As long as that strategy remains profitable and popular, weakness in the currency will be limited. Share sales from NetEase (NASDAQ:) Inc. and JD (NASDAQ:).com Inc. in June will mop up liquidity as traders set aside funds to buy stock, driving up borrowing costs in Hong Kong. The premium between one-month Hibor and the U.S. equivalent is near the widest since 1999, meaning traders will still lose money if they sell the city’s currency against the greenback.

June will also be a month when local banks hoard cash to meet quarter-end regulatory checks, driving up demand for Hong Kong dollars. Listed Chinese companies will buy the city’s currency to pay dividends in the summer, also pushing up interest rates. The Hong Kong dollar traded less than 35 pips from the strong end on Monday, down from 78 pips last week.

That delicate balance will depend in part on how the U.S. responds to China’s actions.

“Investors have been quite concerned with capital outflows,” said Carie Li, an economist at OCBC Wing Hang Bank Ltd. “We haven’t seen signs of that yet and I don’t think Hong Kong will see massive fund exodus unless the U.S. makes an extreme response to the law. The panic will likely last for one to two weeks.”

©2020 Bloomberg L.P.

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