Asset markets in peril as rate cycle swings higher
Ilearned from recent financial news reports that the Hong Kong dollar fell repeatedly against the US unit to the critical level of HK$7.85 for $1 and forced the Hong Kong Monetary Authority to buy Hong Kong dollars with US units, an exercise known as weak-side currency convertibility undertaking. As a result Hong Kong’s banking system lost tens of billions of dollars in liquidity while HK dollar call rates were pushed to new highs in recent years. People should not overlook the impact of interest-rate increases on local real-estate and securities markets.
Since the most recent global financial crisis broke out in the United States in 2008 all central banks in major economies around the world have introduced quantitative easing monetary policies to stimulate economic recovery. In many countries interest rates were kept at very low levels, sometimes close to zero, to boost bank-loan issuance, spending and money circulation. The sudden surge of newly printed banknotes caused a worldwide wave of runaway inflation immediately; while the lasting low-interest environment allowed a deluge of cheap capital to inundate many emerging markets around the world, supposedly chasing high-return opportunities. And everywhere it went stock and property prices skyrocketed, leaving many asset bubbles in its wake.
As economies around the world began to recover from that financial catastrophe, many central banks adopted the QE monetary policy, following the US example. The US dollar experienced a long period of QE operation, which led to a persistently weak dollar against other major currencies, a scenario the largest economy in the world hated to see. That is why the Federal Reserve Board of the US decided to end the QE cycle late last year, in response to continued strong economic recovery, a lower unemployment rate and improvement in other major indicators. In fact, the Fed started to shrink its balance sheet last October, as another step to bring monetary policy back to normal, after starting a cycle of interest-rate increases much earlier. After the Fed raised interest rates last December and in March this year the long-term yield of US Treasuries reached 3 percent at one point, a new high in the recent decade.
Rate increases by the Fed made long-term US Treasuries more attractive to investors; some of the smarter ones took their investment in emerging markets out and bought US debts instead, resulting in a wave of capital draining and higher asset risks in emerging economies. If the Fed raises interest rates three times a year in this cycle some emerging markets may even face the danger of massive loan default. Some emerging economies are reportedly threatened by a rising debt to GDP ratio, which may render them unable to even pay the interest of treasury bonds they sold to foreign investors. Following the Argentine currency crisis last month, the Turkish lira also experienced a sudden collapse and sent stock markets around the world into panic mode yet again. It is quite common for investors to seek greater leverage in times of persistently low interest rates by betting on financial derivatives. When that happens one must keep in mind “never fight battles you cannot win”. As the rest of the world waits for the Fed to raise rates again at its scheduled meeting next week, investors’ need to pull out of emerging markets will grow as well, thus worrying the latter even more.
Because the Hong Kong dollar’s exchange rate with the US unit is fixed at 7.85, known in short as the “peg”, theoretically speaking, the HKMA should raise interest rates in Hong Kong every time the Fed does so in the US but in reality it’s not always true. For example, since the Fed started the current cycle of rate increases Hong Kong has not followed suit at all, as local banks are loaded with cash. However, as long as the “peg” is effective Hong Kong will have to raise its interest rates at some point. The Fed kept US rates unchanged last month but is expected to raise them twice later this year and probably three times next year. That means investors need to pay attention to the impact of credit-cost increases on financial markets, because higher interest rates mean a greater cost of borrowing. When interest rates were low, banks in Hong Kong usually reference one-month or three-month interbank lending rates to decide the interest rate of mortgage loans for housing properties. When local interest rates go up Hong Kong residents will have to pay more mortgage interest. As the latest cycle of rate increases continues people had better be financially prepared for more expensive loans.
Some recent predictions suggest the current cycle of rate increases will no doubt lead to tighter credit and higher risk of debt crises around the world, which may trigger another financial storm during the 2019-20 fiscal year. Treasuries and securities will be adversely affected for sure if that happens in one or two years’ time. Enterprises whose gearing ratio is high (50 percent or higher) will be in greater danger of insolvency.
These are all past experiences but they have been proven true many times and should not be dismissed readily.