HKD Chinese New Year hedging hits bottleneck; spot and forwards diverge
Chinese New Year comes early this year, with festivities starting on January 23, instead of early February, as has been the case in the past couple of years.
That date typically coincides with the conclusion of FX hedging activity for Hong Kong companies. As a result, these large, seasonal FX flows have been compressed into a shorter period, which is creating a bottleneck – and some interesting market anomalies. In any given January, most of hedging is done in the first 21 days of January, but this year it is in the first 10 to 14 days of the month, compressing the large amount of flow going through the market on any given day.
That flow is almost entirely net buying of USD, so the banks that receive that flow then have to go to the market and buy outright USD. That implies buying of spot, and also for outrights, along the forward curve, with six-month, nine-month, one-year and 18-month the predominant tenors in demand.
The outright has the propensity to move a lot faster than the spot, which traders say is the result of diminished liquidity in that market this year. They say the forward portion of the outright has typically been covered first, leading the swap points to go from trading at a discount to trading in a premium. In other words, a significant move to the right.
This has resulted in a curious anomaly for the HKD market. The hedging season would typically see swaps move to the right and the spot USDHKD would rally. However, this year, they have moved in the opposite direction.
USDHKD 3M FWDS
Traders argue that with the reduced liquidity, and the compressed flow, position squaring has brought the front end of the curve into premium, which makes holding a long USD cash position very expensive, which isn’t usually the case. Usually when someone is long dollars in USDHKD, they earn carry in such tenors as tom-next, which is no longer the case. Ton-next on Thursday traded at two pips, whereas typically they are -1.5 pips.
As a result, market makers have had to dump long-dollar positions they were carrying in the very short end, leading spot USDHKD to be heavily offered, while the forward curve is well bid. This dynamic will continue till the Chinese New Year, traders say.
Why is there less liquidity in HKD forwards? Traders say this is probably due to dollar funding positions that have been put through the forward market. The HKD forward market has been a popular funding market because the rates have traditionally been very cheap, and that positioning is now being squeezed.
The option market has also seen a large supply of vega for interbank players. With corporates net buyers of dollars, they have been sellers of vol so that they can generate USD at a discount to where the prevailing outright market is. As a result, it leaves market makers long options, and that has driven vols down. The average duration is somewhere between one and two years, and so that has put a heavy supply into the market.
One-year ATM has come down from 1.25 mid at the end of 2011, to 0.95, which traded on Thursday.
1-year ATM USDHKD volatility
And there may be further to go. Due to the traditional nature of the hedging and the Chinese New Year cut off, it needs to be done, and will be done at whatever the prevailing market price is, says one veteran Hong Kong market maker. “Whilst the market is aware of this, it will always try to squeeze the most value out of it, and once that flow is finished, it should settle down, but that flow is concentrated in these first three weeks, which traditionally lasts over the first five or six weeks,” the veteran says.