Hong Kong's Evolving Carry Trade Dynamics and Funding Cost Volatility: Navigating Risks and Opportunities in a Shifting Landscape

The Hong Kong dollar carry trade, once a cornerstone of global arbitrage strategies, has entered a period of profound uncertainty in 2025. The interplay between the Hong Kong Monetary Authority’s (HKMA) interventions to defend the currency peg, surging funding costs, and shifting investor flows has created a volatile environment for equity and currency markets. This article dissects the evolving dynamics, assessing risks and opportunities for investors navigating this complex landscape.

The Carry Trade’s Boom and Bust Cycle

In early May 2025, the HKMA injected HK$129.4 billion into the market to prevent the Hong Kong dollar from strengthening beyond the strong-side limit of HK$7.75 per USD [2]. This liquidity flood drove the one-month HIBOR to near-zero levels, creating ideal conditions for carry trades—where investors borrowed in HKD and invested in higher-yielding USD assets. The spread between USD and HKD rates widened to 370 basis points, making the strategy highly attractive [3].

However, as carry trade flows swelled, the HKD weakened toward the weak-side limit of HK$7.85, prompting the HKMA to reverse course. By July, aggressive liquidity withdrawals—such as the HK$13.28 billion intervention on July 11—pushed the one-month HIBOR to 1.08% [3]. By August, the HKMA’s 12 interventions between June 25 and August 13 had reduced interbank liquidity by 69%, causing the overnight HIBOR to spike to 2.7678% and the one-month HIBOR to 2.7706% [1]. The narrowing of the USD/HKD spread to 150 basis points rendered the carry trade unprofitable, with 30% of hedge funds unwinding USD-long positions [1].

Equity Market Inflows and Liquidity Pressures

The tightening of liquidity was further exacerbated by record inflows into Hong Kong’s equity markets. Southbound Stock Connect saw HK$35.9 billion injected on August 15 alone, as mainland investors capitalized on undervalued assets [4]. This surge, combined with rising local loan demand, temporarily strengthened the HKD to its strongest level since May 2025. Yet, the broader impact was a further depletion of interbank liquidity, amplifying HIBOR volatility and squeezing borrowers. Homeowners with HIBOR-linked mortgages faced a 200-basis-point increase in monthly payments, while corporate borrowers saw similar hikes in loan costs [2].

Structural Risks and Hedging Strategies

The HKMA’s interventions have exposed vulnerabilities in Hong Kong’s Linked Exchange Rate System (LERS). Derivatives markets now price in a 50% probability of a medium-term peg break—a scenario reminiscent of the 2008 Global Financial Crisis [5]. This uncertainty has forced investors to adopt more dynamic hedging strategies. For instance, USD/HKD forwards and out-of-the-money put options are being used to mitigate potential losses from a sudden peg collapse. Additionally, some investors are diversifying into CNY-linked instruments to reduce exposure to HKD volatility [5].

Opportunities Amid Volatility

While the carry trade’s profitability has diminished, the surge in HIBOR has created new opportunities for savers and depositors. Yields on savings accounts and fixed deposits have improved, offering a rare upside in an otherwise challenging environment [3]. For equity investors, the HKMA’s liquidity management has indirectly supported asset prices by channeling capital into local markets. However, the risks of further policy tightening and a potential peg break remain significant.

Conclusion

Hong Kong’s carry trade dynamics in 2025 underscore the delicate balance between monetary policy, liquidity management, and global capital flows. The HKMA’s interventions have reshaped funding costs and investor behavior, creating a landscape where risks and opportunities are inextricably linked. For investors, the key lies in adapting to heightened volatility through strategic hedging and a nuanced understanding of policy-driven market shifts. As the LERS faces renewed scrutiny, the coming months will test the resilience of both the currency peg and the carry trade’s enduring appeal.

Source:
[1] Hong Kong Dollar Carry Trade Is 'Over' on Soaring Funding Costs [https://www.bloomberg.com/news/articles/2025-08-21/hong-kong-dollar-carry-trade-is-over-on-soaring-funding-costs]
[2] Recent dynamics in the Hong Kong dollar market [https://www.hkma.gov.hk/eng/news-and-media/insight/2025/05/20250520/]
[3] Hong Kong's Currency Peg and Carry Trade Dynamics [https://www.ainvest.com/news/hong-kong-currency-peg-carry-trade-dynamics-navigating-tightening-liquidity-environment-2508/]
[4] HKD Surges to 7.79: Largest Four-Day Gain in 2025 [https://www.ebc.com/forex/hkd-surges-to-7-79-largest-four-day-gain-in-2025]
[5] HKD Carry Trade Opportunities Amid Structural Weakness [https://www.ainvest.com/news/hkd-carry-trade-opportunities-structural-weakness-policy-constraints-2508/]