Following recent disclosure that Bill Ackman's latest so-called 'slam dunk' idea is a bet on a revaluation of the Hong Kong dollar (as described here), it is interesting to see what someone like Deustche Bank's Mirza Baig thought precisely about the trade that Ackman is proposing as some unique concept (in 151 pages no less) as long ago as November 2010. To wit: "Public complaints against inflation are already loud, and may intensify if the reflationary tide swells further. This could turn up the heat on the authorities. Since 1983 when the current regime was adopted, Hong Kong has experienced CPI inflation as high as 12% and deflation as low as -6%. The current inflation rate of roughly 3% looks benign in this context. In 2008 when inflation crossed 5%, the public debate on monetary policy became more intense, but Hong Kong ultimately braced the peg. In short, we feel the situation will have to become far more extreme, and other policy tools prove ineffective before authorities capitulate and allow a revaluation of HKD. At present, the probability of this scenario is low, in our view. This is why we noted earlier that we expect the reval trade to attract more interest from offshore investors, and possibly reach blow-out levels by the middle of ." And after highlighting the Ackman's trade from 10 months later, DB concludes that "[t]he more likely scenario is that Hong Kong will attempt to ride out the reflation tide with its current policy. The public would gradually move to using RMB for payments, and the HKD would fall into relative disuse. Once China’s capital account is sufficiently open (5-10 years later), Hong Kong would endorse the shift towards China through a formal peg vs. RMB at the then prevailing exchange rate (i.e. without any revaluation)."
As for the merit of the actual trade, Ackman's point is that Asian, and specifically Hong Kong inflation will simply get out of control. Yet in that same case, is a simple bet on gold not more profitable? After all, when it comes to politically regulated markets, empirical evidence demonstrates that centrally planned monetary regimes will do everything but what is most logical (especially when it is far easier to simply intervene in the market at first: something the SNB demonstrated so well in the past year). How long have people been calling for China to reval the CNY? How has that worked out so far?
So while the Ackman trade will indeed be profitable in a very low probability binary outcome case, what will likely be just as profitable is a bet on that ultimate non-dilutable currency, whose primary driver incidentally are all those Hong Kong investors who are buying the yellow metal specifically due to the abovementioned concerns.
Ackman is suggesting that the market is mispricing the possibility of a revaluation. Well, what if the market is pricing the probabilities perfectly and instead has focused on capturing the central-planning inflation threat uncertainty by going long non-dilutable monetary equivalents which the government is unable to peg?
Which is not to say we think that Ackman is wrong: the truth is nobody can predict what Hong Kong authorities will decide to do. However, what is certain is that Deutsche Bank has been correct in its prediction of not only what will happen to the Hong Kong economy (and its currency), but also in anticipating the advent of the Ackman trade. It also suggests that the final outcome is very much a different one:
The more likely scenario is that Hong Kong will attempt to ride out the reflation tide with its current policy. The public would gradually move to using RMB for payments, and the HKD would fall into relative disuse. Once China’s capital account is sufficiently open (5-10 years later), Hong Kong would endorse the shift towards China through a formal peg vs. RMB at the then prevailing exchange rate (i.e. without any revaluation).
There remains a risk that authorities are forced to act if the reflationary tide swells beyond control. We thus suggest positioning for higher HKD interest rates and a stronger currency via low-delta options. Specifically, we would be buyers of 1Y USD/HKD put with a strike at 7.40 for roughly 35bps, and pay rates via 2Y1Y swaptions. Note that recently swaption vols have come off, despite increased speculation on HKD regime shift. It seems the market believes in a currency revaluation, but has not considered that a regime shift will translate into higher interest rates as well.
Finally, we would strongly advise against fading the recent uptick in speculative pressure. We think Hong Kong’s reflationary tide is likely to swell further, and market speculation on a HKD revaluation will probably intensify. Trying to fight this trend (even with the right view on policy) risks incurring mark-to-market losses
Full Deutsche Bank presentation: