18 ★ Tuesday 27 August 2019

David Riley

Markets Insight

T

he fastest-growing asset

class so far this year? Nega-

tive-yielding bonds that, if

held to maturity, are guar-

anteed to impose a loss on

investors. The stock of such bonds has

almost doubled since the start of the

year to about $16tn — or one-third of the

global bond market.

Many commentators have dismissed

the fall in yields and rise in negative-

yielding debt as evidence of a bond bub-

ble. But it is not a reflection of investors’

irrational exuberance. It is a call for

politicians to act to prevent a deflation-

ary global economic downturn.

The best explanation for the dramatic

decline in high-grade government and

corporate bond yields worldwide is that

investors are responding rationally to

the rising risk of a global recession.

Business confidence and investment

are being eroded by the uncertain ebb

and flow of the US-China trade war, the

threat of US tariffs on autos and Brexit,

along with the slowing Chinese econ-

omy that has been the bedrock of

growth for many global (and especially

European) manufacturers.

The fall in bond yields globally is

fuelled by investors’ desire to hedge

growth-sensitive risk assets against the

backdrop of rising uncertainty.

This is a reflection of fears that the

world could fall into recession rather

than evidence of an indiscriminate grab

for yield, engineered by central banks.

The dovish pivot from the US Federal

Reserve at the start of the year, along

with subsequent policy easing by the

European Central Bank, has lowered

actual and expected short-term interest

rates. Long-term real inflation-adjusted

rates have also fallen as investors revise

down their expectations for global

growth, in response to a populist back-

lash to globalisation and liberalisation.

What is also different this time is that,

at this stage of the economic cycle, the

Fed is the only major central bank with

room to meaningfully cut interest rates,

albeit to a smaller degree than in previ-

ous downturns.

Policy rates in Europe and Japan are

effectively at their lower bound — any

moves below would constrain the sup-

ply of credit and would encourage sav-

ing rather than investment, as well as

posing risks to financial stability.

One obvious consequence of negative

policy rates is the challenge it represents

to the business model of financial insti-

tutions. Investors, meanwhile, are

forced to take on more risk in duration

— or the amount of time it takes for a

bond’s coupon payments to recompense

an investor for the initial purchase

price. That renders the supposedly

“safe” assets in their portfolio vulnera-

ble to even a modest rise in bond yields.

Investors are rightly sceptical that

marginal cuts in interest rates and more

quantitative easing, pulling bond yields

even lower, will raise inflation expecta-

tions and boost spending, given the gen-

eral growth outlook.

What is needed is reduced uncer-

tainty around trade policy, including

the lifting of the threat of US auto tariffs,

and growth-friendly fiscal policies to lift

business confidence and boost demand.

Mario Draghi, ECB president, recently

said that, if there were a worsening in

the eurozone economy, “significant fis-

cal policy becomes of the essence”. He is

right. The eurozone’s bond market is

shouting that fiscal policy is too restric-

tive — and by way of encouragement is

offering to pay the German government

and others to borrow and spend.

A debate on fiscal stimulus by the

eurozone’s largest economy is under

way in Berlin but it lacks the urgency

that investors are calling for — and

which the deteriorating German and

eurozone growth outlook warrants.

The Japanese government, for its

part, should again defer its planned

increase in sales tax in October.

Government bonds remain an impor-

tant diversifier of the growth risk in

investor portfolios, despite these low

and often negative yields. But investors

must also be wary of painful market

losses from even a partial normalisation

of interest rates.

There has been little choice but to try

to make money by exploiting shifts in

pricing and volatility along the curve

while taking idiosyncratic risks in sover-

eign and corporate credit.

Asset bubbles are characterised by

cheap money fuelling a credit-financed

rise in asset prices to levels not matched

by fundamentals. Each time, the pros-

pect of further price appreciation is jus-

tified by increasingly outlandish claims

of “this time it is different”.

But this year’s dramatic fall in bond

yields and surge in negative yielding

debt are a call for fiscal policy to support

growth. Monetary policy is not yet

wholly impotent but politicians need to

heed the markets’ plea to reduce trade

tension and adopt fiscal policies. Sooner

or later governments — rather than cen-

tral banks — will have to take the lead.

David Riley is chief investment strategist at

BlueBay Asset Management in London

Negative yields are

a plea by investors

for fiscal stimulus

The exchange rate peg of the Hong Kong dollar to its US peer shows few signs of breaking down— Bobby Yip/Reuters

Hong Kong’s dollar peg

undaunted by unrest

HK per US







   

Peg introduced

Sources: Bloomberg; Hong Kong Monetary Authority



Hong Kong’s dollar peg

is backed with heavy

financial firepower

Hong Kong exchange fund v

monetary base (HKtn)

    

Exchange

fund

Monetary

base

HKMA US dollar assets to back

monetary base

Other HKMA investment and assets

Exchange fund bills and notes

Currency in circulation

Aggregate balance

As of Jun 

H U D S O N LO C K E T T— HONG KONG

This summer’s protests against a pro-

posed extradition law with China have

shaken Hong Kong to its foundations.

But when some in the protest move-

ment tried to put the squeeze on the

city’s financial system — where the local

currency has long been pegged to the US

dollar — the effort barely registered.

One user of the protesters’ main

online discussion forum called for

massed cash withdrawals and currency

conversions a couple of weeks ago, to try

to cause grief for local banks.

“Converting to a foreign currency

(like the US dollar) also protects your-

self, so if the currency peg goes pear-

shaped, you won’t be left holding Hong

Kong dollars,” the protester urged.

Pictures showing large stacks of bank-

notes withdrawn by Hong Kongers pep-

pered social media that day but the

Hong Kong dollar, which can move

within a narrow trading band against

the greenback, finished trading just

fractionally weaker.

Indeed, despite worries over China’s

strengthening grip on its special admin-

istrative region, a gloomy economic out-

look and bearish talk on the Hong Kong

dollar from investors including Kyle

Bass, the 36-year-old exchange rate peg

shows few signs of breaking down.

“The Hong Kong economy is obvi-

ously going through one of its toughest

times but I do not see the peg breaking,”

said Ben Kwong, senior multi-asset

strategist at State Street Global Markets.

The peg was introduced in 1983 to

stop runaway depreciation of the then

free-floating currency, which was

sparked by negotiations between the

UK and China over Hong Kong’s future.

Bar some tweaks in the 2000s, the

system is mostly unchanged since then.

The currency board is run by the

Hong Kong Monetary Authority, which

acts as ade factocentral bank but does

not engage in monetary policy like the

Bank of England or US Federal Reserve.

Instead, the HKMA has a mandate to

buy up Hong Kong dollars for US dollars

when outflows push the exchange rate

to the trading band’s weaker limit. This

leaves banks with fewer funds for short-

term lending and eventually drives up

interest rates enough to make Hong

Kong dollar assets more attractive than

their US dollar counterparts, encourag-

ing inflows that strengthen the

exchange rate. The reverse is done when

the currency gets too strong.

Perhaps the most serious challenge to

the peg came in 1998 during the Asian

financial crisis when George Soros, fresh

from successful short attacks on the cur-

rencies of Thailand and Malaysia,

launched a dual assault on Hong Kong’s

currency and stock market.

The HKMA spent about $15.1bn fend-

ing off Mr Soros and other short sellers

but won out.

The latest notable attempt to under-

mine the currency came in April from

Mr Bass, a Dallas-based fund manager

who rose to prominence by shorting the

US housing market ahead of the global

financial crisis.

In an investor letter sent that month,

Mr Bass claimed that the HKMA had

spent 80 per cent of its reserves — which

he identified as the “aggregate balance”

— over the previous 12 months, leaving

it with precious little firepower, about

HK$54bn ($7bn), to defend the peg.

“Hong Kong currently sits atop one of

the largest financial time bombs in his-

tory,” he concluded.

Invesco chief economist John Green-

wood, who proposed the currency

board to Hong Kong’s government in

1983, said Mr Bass’s argument was

flawed.

“He’s confusing assets and liabilities,”

Mr Greenwood said, pointing out that

the aggregate balance was the total

reserve accounts of commercial banks

held at the HKMA and thus “would

never be used, couldn’t be used” to

defend the peg.

At almost $450bn, he said, Hong

Kong’s actual foreign exchange reserves

were enough to cover all publicly circu-

lating banknotes, the local currency

holdings of banks and their reserves

held at the HKMA more than twice over.

“Bass has just got that wrong and he’s

frankly ignorant,” Mr Greenwood said.

Mr Bass told the Financial Times that

the aggregate balance was equivalent to

excess reserves. He said the cumulative

pressure from outflows, lack of faith in

Hong Kong’s government, the inevitable

collapse of untenably high real estate

prices and other factors would ulti-

mately break the peg. “When pegs

break, it’s never monocausal,” Mr Bass

said. “You’d have to be an absolute fool

today to not convert all your Hong Kong

dollar deposits into [US dollars].”

Mr Bass has also argued that the

HKMA’s available firepower is “a mea-

gre 13 per cent of reported reserves” and

“woefully inadequate,” on that basis.

But Howard Lee, deputy chief execu-

tive of the HKMA, said forex reserves

held in the currency board’s portfolio

specifically dedicated to providing full

US dollar backing for every Hong Kong

dollar were composed of high-liquidity

assets like US Treasuries equivalent to

111 per cent of the monetary base.

Analysts said that, further down the

line, the peg could come under greater

pressure as the 2047 deadline

approaches for the end “one country,

two systems”, which preserves Hong

Kong’s civil freedoms and independent

legal infrastructure for 50 years after

the handover from Britain in 1997.

Some speculate that a re-pegging to

the renminbi could come before then to

ease the transition but the HKMA has

stressed that such a move would remain

impossible until certain conditions were

met, including China’s currency becom-

ing freely convertible and its capital

account fully opening.

As one top Hong Kong government

official joked about the peg’s long-term

prospects: “Don’t certify this death yet.”

Additional reporting by Nicolle Liu

Currencies.Short bets

Hong Kong peg holds firm in face

of speculators and protesters

Territory’s dollar stands strong

as fund manager Bass says you

would be a ‘fool’ to hold on to it

The best explanation is

investors are responding

rationally to the rising

risk of a global recession

‘The Hong Kong economy

is going through one of its

toughest times but I do

not see the peg breaking’

AUGUST 27 2019 Section:Markets Time: 26/8/2019 - 17: 45 User: stephen.smith Page Name: MARKETS2, Part,Page,Edition: USA, 18, 1

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