Sept 14 (Reuters) - The Hong Kong dollar has retreated from its sharp rally last week triggered by the yuan’s rise and broad weakness in the U.S. dollar, but analysts expect low interest rates will keep the currency on the weaker side of its narrow trading band.
The Hong Kong dollar spot rate was marginally firmer against the dollar at 7.8116 by 0758 GMT on Thursday, and is on track to finish the week slightly higher, preserving all of its gains from last week.
The pegged currency rallied sharply and unexpectedly against the dollar on Friday, when it tore through the crucial 7.8 level to the higher side of its 7.75 to 7.85 currency band after steadily depreciating against the dollar all of this year.
It rallied 0.17 percent over Wednesday to Friday last week, after having declined about 0.9 percent in previous eight months.
Analysts said they expected the Hong Kong dollar to remain weak, primarily because of a widening interest rate differential as the Federal Reserve progresses with rate rises.
It has raised rates twice this year and is expected to reveal next week its plans for unwinding massive fiscal stimulus introduced after the financial crisis.
“It (the U.S. dollar-HK dollar value) still should go higher because of the onshore rates are still very low, relative to the U.S. rates,” said Andy Ji, currency strategist at Commonwealth Bank of Australia.
”It doesn’t matter how gradually the U.S. is tightening monetary policy. For Hong Kong, liquidity is too flush. There is no way it can soak up enough liquidity, so that’s the main driver for the Hong Kong dollar,” Ji added.
The sum of balances maintained by commercial banks with the Hong Kong Monetary Authority (HKMA), also called the ‘aggregate balance’, was HK$227.54 billion ($29.13 billion) as of Wednesday’s close, a notable drop from end-August.
It had beene as high as HK$426.34 billion in late 2015, but has been steady around the HK$260 billion level in the past 12 months.
HIBOR-LIBOR spreads, the differential between floating rates at which banks lend to each other in Hong Kong and the U.S. respectively, have been gradually widening since 2015, and the 3-month spread is now 0.56536 versus -0.02878 basis points at the beginning of this year.
“Last week’s rally happened mainly because of the European Central Bank meeting a day before -- no one knew what would happen, everyone was long euro. Also, there was the North Korea threat,” a trader said.
“The market was long U.S. dollar against the Hong Kong dollar. If North Korea launched a missile over the weekend, the dollar could further fall. So the market unwound its previous dollar position.”
At the end of last week, the dollar was at its weakest in more than 2-1/2 years against a basket of major currencies as the euro jumped after a Reuters report showed that ECB policymakers were in broad agreement that their potential next step would be to reduce their bond purchases.
Dollar bearishness was exacerbated by fears North Korea may test fire another missile over the weekend, Hurricane Irma sweeping the western coast of the United States of America, and reduced expectations of another rate hike by the U.S. Federal reserve this year.
Broad dollar weakness forced the unwinding of long dollar positions across currencies, with the yuan blowing past the 6.5 per dollar level.
The yuan’s rally onshore was echoed by sharp gains in the offshore yuan -- which touched its highest since March 16 -- and the Hong Kong dollar.
“The sensitivity of the USD-HKD to the USD-CNY picked up as the latter broke the 6.5 level,” said Wee Choon Teo, FX strategist, Asia ex-Japan, at Nomura.
Analysts believe widening spreads and ample cash in the Hong Kong dollar market, compounded by a central bank constrained by policy choices, will keep the currency mired in the weaker end of the trading band.
But the currency is still far from levels that would spur any intervention by the HKMA, analysts said.
“They (HKMA) are not in a market to influence the interest rates. So, any intervention in terms of liquidity withdrawal is going to be very minimal. That is until it hits the top of the band and they are forced to intervene. Till then they just wait and watch and hope the U.S. doesn’t raise rates faster than expected,” said Ji.
Most market participants do not expect the HKMA to intervene unless the Hong Kong dollar falls to the lower end of the trading band, forcing the de facto central bank to start selling dollars and withdraw Hong Kong dollar liquidity. ($1 = 7.8118 Hong Kong dollars) (Reporting By Rushil Dutta in Bengaluru; Editing by Kim Coghill)