Unrest in Hong Kong, yield curve inversion, and rising global macro risks

What is the real impact on financial markets of the evolving situation in Hong Kong and recent global economic events?

As developments in Hong Kong continue to evolve, what is the impact on financial markets? While there are solid indications that tourism and retail sectors have begun to suffer over the past weeks, we believe the strong fundamentals of Hong Kong’s currency management will keep the peg intact.

In a recent conversation between Alex Wolf, Head of Investment Strategy for J.P. Morgan Private Bank in Asia, and Paul Thompson, Head of Investments for Hong Kong and the Philippines for J.P. Morgan Private Bank, we analyzed the impact on the economy, currency and the broader financial sector.

The economic and financial impacts of recent developments in Hong Kong and the recent U.S. yield curve inversion were the two pressing topics discussed during the calls.



We don’t expect the Hong Kong Dollar (HKD)/U.S. Dollar (USD) peg to break.

The peg has been in place since the early 1980s and has survived financial crises, SARs,1 and moments of political uncertainty. Hong Kong uses a "currency board" to peg the HKD to the USD. The main feature of the system is that by pegging the HKD to the USD, the Hong Kong Monetary Authority (HKMA) must follow the U.S. monetary policy and must maintain foreign exchange (FX) reserves equal to or greater than existing money supply. The drawbacks of this system are that the HKMA cannot implement independent monetary policies, cannot set interest rates, cannot run quantitative easing (QE) or expand its balance sheet to stimulate the economy. These are the drawback of a stable currency peg.

There are three reasons that may cause a peg break: forced exit by markets (most common), a deliberate break for economic reasons, and a regime change. Currently, we don’t see any of these scenarios applicable to Hong Kong’s situation.

Hong Kong has a very well-managed currency board mechanism: If HKD liquidity drains due to outflows, the money supply contracts and interest rates (Hibor) naturally rise. This attracts money back to the system, creating a natural balance between interest rates, the exchange rate and money supply. Meanwhile, Hong Kong has adequate foreign currency reserves, meaning that every unit of the HKD is more than fully backed by the USD at the conversion rate. Further, the HKMA follows a very disciplined approach to managing the linked exchange rate.

While there might be longer-term considerations regarding the kind of currency system Hong Kong wants to have, in the foreseeable future the peg is unlikely to break.


Similarities and differences between Hong Kong and Argentina currency peg

The main similarity between Hong Kong and Argentina is that both used a “currency board” to peg the currency. A currency board links a currency to an anchor currency, but there are unique aspects of a currency board that differentiate it from other systems of pegged exchange rates. A clear difference between Hong Kong and Argentina is how they managed these boards. Hong Kong followed strict, disciplined guidelines, which is why the peg has lasted, whereas Argentina did not.

A currency board must meet three key criteria: First, the board must maintain a fixed exchange rate with its anchor currency; second, it must allow for full convertibility; third, the monetary liabilities of the currency board must be fully backed in hard—that is, foreign currency—assets. Every unit of domestic currency must be backed and convertible for the anchor currency at the fixed rate, meaning every single HKD has to be backed by the USD. So theoretically, every single currency note could be exchanged for dollars, if need be.

Argentina’s currency board violated all of these rules at some point in its existence. The government allowed the currency to be partially backed by domestic—rather than hard foreign currency—assets. In addition, Argentina had been running massive fiscal budget deficits for some years.

Hong Kong’s management of the peg bears few, if any, similarities with Argentina—it runs a structural surplus and closely adheres to the “guidelines” for running a successful currency board. Therefore, short of a political decision, there is very little risk of the peg “breaking.”



Macro data suggests a significant economic impact from the protests. In response, the Hong Kong government revised down its year-end GDP growth to 0–1% on August 15, and there may be further downgrades.

From what we can see, the social unrest is having a very large, negative impact on the local economy, but there still isn’t enough data to know the depth of the impact. Broadly, tourism, retail and services industries will feel the brunt of the impact. The July composite Purchasing Managers’ Index (PMI) was 40.5 (below 50 means contraction),2 reflecting the lowest figure since the financial crisis. The June retail sales number and visitor arrivals also declined sharply.

Externally, slowing global trade and uncertainty emanating from the trade war are also weighing on growth. Similar to Singapore, which has forecast negative growth in 2019, Hong Kong is also a trade-exposed economy. Therefore, we see a combination of local and global factors putting pressure on growth.



While the U.S. market remains a preferred market, the recent inversion of the 2-year–10-year yield curve4 sparked wide concerns over a recession.

From an economic standpoint, normally the yield curves slope upward as investors are compensated with higher yields for lending over a longer period of time. An inversion in yield curve simply reflects market expectations of weaker growth and inflation in the future.

Historically, the inversion is not a 100% accurate indicator. Seven out of nine times an inversion correctly predicted a recession. Time lag in between varied from nine to 26 months.

It is also a noisy indicator. We often say it is near impossible to predict the timing of a recession. Usually, people will not realize a recession has come until they are already in one. The gap between an inversion and the equity market peak ranged from two to 19 months historically. Therefore, it may not be a very helpful indicator, as it can hardly predict the timing. Additionally, the reason for inversion is also important. Usually when the yield curve inverts, it’s because the Federal Reserve Board (Fed) is tightening policy and it goes too far. In those instances, it raises short-term rates too high, and the cost to borrow rises above the potential return on investment. This time around, the Fed has already acknowledged growth concerns and is taking action to address them by easing—but the market thinks the Fed needs to cut rates faster and further to keep the U.S. economy humming along. Meanwhile, foreign investors are dealing with negative yields, so they’re flocking to the United States to try to lock in positive rates on the long-end. To that end, it’s not that the Fed has raised short-term rates too high, but rather that long-term rates are reflecting the slower global growth environment.

We expect weaker growth, but not necessarily a recession. The United States has had above-trend growth recently, and it is weakening toward the trend. In any economy, weakening growth increases the risk of a recession, but by no means guarantees it.


The U.S.-China trade talks have turned negative and more unpredictable. Escalation has reduced trust and the ability to reach a deal before the 2020 U.S. election. To recap—immediately after the Shanghai talks, President Trump announced a tariff escalation and China responded by allowing the RMB to depreciate above seven. This was quickly followed by the U.S. Treasury labeling China a currency manipulator.

These tit-for-tat actions have reduced any remaining trust and made future negotiations very difficult. The loss of face coupled with the upcoming 2020 U.S. presidential election have made China less willing to negotiate or offer trade concessions. On the U.S. side, there is little room left for escalation either, as further tariffs would have to be on consumer goods, upsetting voters and adding to the risk of a recession prior to the election.

In the United States, a debate is raging between dealmakers and more hawkish hardliners. Dealmakers want a deal; they generally agree to challenge China to get better terms on trade but are supportive of deeper economic relations with China. On the other side, the hardliners are pushing to reduce trade and all other economic ties with China. Currently, it is unclear which side will win out.

Many tend to expect binary outcomes, namely either a deal to resolve the issue or further escalation. But throughout history, a number of trade wars remained as “frozen conflicts” for many years, creating a new normal of higher tariffs, permanently restricted markets, and supply chain redirection.

Our base case forecast is for no deal prior to the 2020 election, but no substantial escalation either. Existing tariffs will likely remain, and supply chains will adjust to a new normal. The existence of tariffs for the near or medium term means uncertainties will stay, and we expect to see PMIs, capital expenditure and trade to stay weak across most large economies.  


We continue to stress that the global economic cycle is in its later stages.

Economically, we see weaker data worldwide. Germany posted negative GDP growth for Q2; China’s July data suggest weak fundamentals; G3 countries and China all had negative year-on-year growth of capital goods import, which suggests weak capital expenditure globally. One relatively bright spot is the resilient service industry, and especially consumer spending. We saw Alibaba and U.S. July retail sales post good results. Traditionally, services will follow the trend of manufacturing, so the gap might close as time goes by, but for now there are still bright spots.

The combination of the trade war, the Argentina election, Brexit uncertainty and the ongoing unrest in Hong Kong are all raising economic and market uncertainty.

The general advice across bond markets is to stay liquid, stay high-quality and extend duration. We now prefer investment-grade bonds with five to seven years of duration. On equities, we see good opportunities in the healthcare sector and high-dividend stocks. Alternative investments, especially specific hedge fund strategies (i.e., relative value, global macro, beta neutral), have performed well in this high-volatility environment.

We can help

Speak with your J.P. Morgan representative about how these economic insights might inform your unique wealth plan.

2 Source: Markit/Haver Analytics; data as of July 31, 2019.
3 Source: Markit/Haver Analytics; data as of June 30, 2019.
4 The spread between 10-Year and 2-Year Treasury Constant Maturities, which can indicate perceived economic outlook.





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