Property – Keep stepping on the brakesThe Hong Kong Monetary Authority (HKMA) on 10 June announced new measures to tackle housing-price inflation. The intention this time， as in previous rounds， is to limit leverage. The government also said it would introduce more land supply in Q3-2011， which would create about 6，000 new residential units. In 2010， 13，405 residential units were completed.The HKMA’s latest measures came as leverage levels were already falling – the loan-to-value ratio for new mortgages now stands at a record-low 54.5%. Despite significant property price gains of 24% y/y， 11.5% year-to-date， and 5% from the 1997 peak， income gearing still looks reasonable， particularly compared to the 1996-97 craze (see Chart 1). The recent repricing of mortgages and the HKMA’s previous measures have also helped to cool sentiment of late， as well as transaction volumes.Income gearing tells us about affordability. Rental yields are another measure of valuation. Admittedly， current nominal rental yields appear very low by historical standards; yet unlike in the 1990s， people are still asking for reasonable returns on their investment over mortgage rates and deposit rates (see Chart 2). We acknowledge that the prevailing low interest rates will not last forever， and that these valuation measures are bound to deteriorate when interest rates start to head higher， possibly in 2012. Hence， while we do not view Hong Kong’s real-estate market as being in a bubble now， we see a genuine risk of one forming in 2012-13.This， together with still-favourable fundamentals –rising household incomes， a perceived supply shortage， and demand from mainland) China – means that the authorities will continue to do what they can to prevent the creation of a bubble or， if it does happen， to limit the impact when it bursts. Other than introducing more land supply and further limiting leverage， the government is considering whether to restart the Home Ownership Scheme， which offers government-subsidised flats for sale; the decision， expected to be announced in the October Policy Address， will be closely watched.Inflation – Darkest before dawnCooling the property market this year will pay great dividends in capping CPI inflation in 2012. Housing rents make up 32% of the CPI basket. However， we expect the private housing component of the CPI (CPI-PH) to continue to trend higher at least until Q4-2011， irrespective of the measures introduced by the authorities. Why? The CPIPH tracks the average rent of all private residential flats， not just new rentals. With rental contracts normally running for two years， the CPI-PH mirrors the 24-month moving average of the Property Rental Index (24mma PRI). Chart 3 shows the trajectory of CPI-PH， assuming current PRI levels for the rest of 2011.Housing is just one part of the bigger inflation story –that the drivers are gradually shifting from being exogenous to endogenous. Exogenous factors include the expected stabilisation of food prices， both globally and in China， in H2-2011 and the return of the favourable base effect. In terms of endogenous factors， housing rents aside， it is worth noting that Hong Kong’s unemployment rate has more or less returned to pre-crisis levels since Q1-2011. A tighter labour market has historically supported more domestically oriented inflation drivers， such as miscellaneous services， the largest CPI component outside of food and housing (16.2%).The good news is that rising inflation will continue to reflect Hong Kong’s strong domestic fundamentals and demand. We forecast 5.2% CPI inflation for full-year 2011 on the back of 6.0% GDP growth. The bad news is that interest rates cannot rise soon or fast enough to ease inflation concerns. This also means that even if CPI inflation does peak later this year， the subsequent improvement is unlikely to be dramatic.Liquidity – In search of qualityLocal monetary conditions are determined by US interest rates and capital flows. We expect the Fed to start hiking rates only in Q3-2012; in our view， this means that USD LIBOR， and therefore HIBOR， will only start a sustained trend higher in Q1-2012 at the earliest. Separately， Hong Kong continues to sit on a large pile of liquidity. The Aggregate Balance， a gauge of interbank liquidity， stands at HKD 150bn， versus the norm of less than HKD 5bn – a result of massive safe-haven inflows after the outbreak of the global financial crisis. This buffer appears to be more than sufficient， even in the case of transitory outflows， which would initially be evidenced by a weaker Hong Kong dollar.Why all the recent talk about liquidity tightness among Hong Kong banks? Simply put， banks in Hong Kong do not lack liquidity per se， but only ‘good-quality’ liquidity. What constitutes such liquidity? Deposits – the longer the tenor， the better. In other words， liquidity that can help to reduce banks loan-to-deposit ratio. This ratio for banks in Hong Kong has been climbing (see Chart 4) on the back of fast loan growth and， to some extent， the gradual redenomination of deposits from HKD and other foreign currencies into the much less‘deployable’ Chinese yuan (CNY). This helps to explain why banks have been paying up for deposits， repricing mortgages as well as trade finance loans in recent months， yet HIBOR has remained steady. Liquidity from the interbank market cannot help a bank’s loan-to-deposit ratio.Greece concerns are capping HKD ratesThe US Treasury rally fuelled by Greece-related debt concerns and weak US economic data has driven HKD rates lower， in line with regional rates markets. The bond and swap curves bullish steepened over the month as concerns over the impact of a potential Greek default on the global banking system continued to bolster demand for longer-term rates. This was evidenced by the bid/cover ratio for the latest 10Y EFN auction， which came in higher than consensus， at 3.64x.Although yields and swaps appear more at risk of a correction at current levels， they remain capped by ongoing uncertainties surrounding the resolution of the debt crisis for now. With short-term rates likely to remain well anchored amid ongoing flush liquidity， we expect both the bond and swap curves to remain directional， with risks tilted towards a bearish steepening should a prompt resolution to the debt crisis be achieved. In addition， while narrow bases have kept shorter-term HKD/USD swap spreads range-bound， the 10Y HKD/USD swap spread appears relatively wide， currently at the top end of its recent trading range. We would therefore recommend a 10Y spread narrower should rates sentiment turn more bearish， given the historical tendency for the spread to narrow during a sell-off.
