When last week Hong Kong's overnight CNH funding rates exploded to the highest since January, many ascribed it to the liquidity scarcity ahead of Chinese holidays on Thursday and Friday. However, we claimed that as the PBOC continues its struggled to prevent USDCNH from rising above 6.70, pushing funding costs to stratospheric levels was precisely one of the tools it was using.

As we explained last Wednesday, "one reason for the latest surge in funding costs is that with Chinese and Hong Kong holidays on deck, liquidity is scarce. The Hong Kong market will be closed on Friday for the mid-autumn festival and the China markets will be closed on Thursday and Friday. China has traditionally intervened in currency markets just before holidays: last October using illiquidity just before its long National Day celebrations to intervene in Hong Kong and reduce an embarrassingly wide gap between the offshore and onshore rates. Of course, next week we will have the Fed and BOJ meetings as well, where uncertainty is leading to even more illiquidty."

However, the most likely explanation is that in order to force Yuan shorts to capitulate as 6.70 remains just barely within reach, the PBOC is simply continuing to squeeze the yuan shorts and raising the cost of shorting yuan, as explained last week. Ultimately, the PBoC weakened its yuan fix by 169 pips to 6.6895 versus yesterday’s 6.6726, even as many were expecting the USDCNY to finally breach the the 6.70 resistance level, the defense of whjich may have explained today's aggressive spike in HIBOR tightening.

This theory was validated overnight when the overnight interbank yuan rate surged the most since January in Hong Kong amid what Bloomberg said was "speculation China’s central bank is intervening to fend off bearish bets on the currency." The offshore yuan funding cost, known as Hibor, jumped 15.7% points in its second-biggest gain on record to 23.7% according to a fixing from the Treasury Markets Association. That’s the highest since January, when the People’s Bank of China was also suspected to be mopping up liquidity to boost the exchange rate. Funding conditions tightened on Monday even after the Hong Kong Monetary Authority said Thursday banks in the city had tapped its liquidity facilities. The three-month yuan interbank rate climbed 81 basis points in Hong Kong to 5.86%, the highest since February, while the one-month rate increased to an eight-month high.

As we explained previously, amid expectations that the Yuan was tumbled following the end of last week's G-20 meeting in China, the yuan instead stabilized as offshore funding costs climbed ahead of last week’s holidays and amid speculation the PBOC was engineering a squeeze. Such a crunch would help discourage short positions on the currency before the Federal Reserve’s review of monetary policy this week and the yuan’s entry into the International Monetary Fund’s basket of reserve currencies next month.

A jump in yuan Hibor hurts bears in two ways: by increasing the cost to borrow the currency and sell it, and also by prompting lenders that want to avoid paying the higher rates to buy the yuan they need in the spot market instead, bolstering the exchange rate. The rate surged to a record 66.8 percent in January, prompting turmoil in local and global financial markets.

“The result is to support the currency at a time when 6.70 suddenly seems a very important line in the sand,” said Michael Every, Hong Kong-based head of financial markets research for Asia-Pacific at Rabobank Group. “You’d almost think it was a pegged currency.”

Sure enough, the USDCNH has remained under 6.70 however at a price: namely the PBOC tipping its hands that it has to actively punish Yuan shorts by making shorting effectively impossible.

Additionally, despite last week's dollar gains, the PBOC strengthened the yuan’s fixing by 0.16 percent Monday, in another sign stability is preferred before the U.S. and Japan both deliberate monetary policy this week.

There is another reason why rates have soared: according to Sue Trinh, Royal Bank of Canada’s Hong Kong-based head of Asian foreign-exchange strategy, the recent crunch was partly caused by the PBOC not rolling over its forward positions from last year . Chinese banks were suspected to have sold dollar-yuan forwards last year at the PBOC’s behest, and now that these positions aren’t being extended, the lenders have to settle the contracts by delivering yuan.

“It is reasonable to say that the Chinese authorities are increasingly ‘de-sensitizing’ the yuan from external uncertainties and potential shocks from the Bank of Japan and Fed this week,” said Christy Tan, head of markets strategy in Hong Kong at National Australia Bank Ltd. Tight liquidity before Mid-Autumn Festival holidays last week and the weeklong break in October “provides an additional avenue for the Chinese authorities to maintain the squeeze and ward off speculative selling in the offshore yuan,” she added.

Some more sellside observations on the ongoing liquidity squeeze in the Hong Kong overnight market:

Rabobank Group (Michael Every, head of financial markets research for Asia Pacific)

Hibor isn’t as high as in January but same message is being sent

CNH liquidity is tight either by design or by error; result is to support the currency at a time when 6.70 suddenly seems a very important line in the sand. See more

RBC (Sue Trinh, head of Asian FX strategy)

If China doesn’t roll over positions built during the intervention last yr as they come to maturity it removes CNH liquidity from the market

As intervention was heaviest in Sept. 2015, funding squeeze related to 1-yr fwd intervention last year maturing will abate

Societe Generale (Frances Cheung, head of Asia ex-Japan rates strategy)

CNH Hibor rates are probably boosted by temporary demand on offshore yuan as China might choose not to rollover previous positions in forward market

Liquidity is tightening as previous forward/swap positions that China probably built since last August mature. See more

Mizuho Bank (Ken Cheung, FX strategist)

CNH liquidity remains tight despite HKMA yuan injection, suggesting market participants are cautious in offering CNH in the interbank market

Soaring carry costs for short positions appear to reverse bearish sentiment on the yuan

Cash supply will remain relatively tight as HKMA’s liquidity injection looks to have failed to smooth over concerns

NAB (Christy Tan, head of markets strategy)

Chinese authorities are increasingly “desensitizing” yuan from external uncertainties from BOJ and Fed meetings this week; Preference is for currency stability ahead of the October 1 SDR entry

Thin liquidity ahead of the Mid-Autumn holiday and then the Golden Week holidays provides an additional avenue for China to maintain the squeeze and ward off speculative selling in CNH

Commerzbank (Zhou Hao, economist)

Betting against yuan won’t be profitable now

PBOC is trying to squeeze out bears by pushing the costs to short the currency very high

It remains to be seen how long the PBOC can maintain this charade of stability and lack of outflows at the expense of crushing shorts and anyone else who dares to take on the Chinese central bank.