High Rate to Intensify Term Spread Reversal
The author is an analyst of KB Securities. He can be reached at jk.lim@kbfg.com. -- Ed.
Near-term concerns easing, but fundamental issues remain
KTB yields should retreat for a while on hopes for a U.S. Fed pivot amid slowing economic indicators and the U.K.’s efforts to stabilize its financial market. The yield decline should be seen as a trading opportunity given lingering fundamental issues (e.g., USD appreciation stemming from Fed tightening, strong U.S. economic fundamentals) and U.K. fiscal policy. In the U.S., headline inflation has taken a downturn, though core price indices have yet to show any signs of slowing, and the no. of new unemployment benefit claims indicate a solid job market. The Fed could lower its rate hikes to 50bps in December, but based on what has happened so far this year, we will just have to wait and see. In the U.K., the recent decision to scrap a bill aimed at cutting its highest income tax rate increases the likelihood of the country changing its stance on tax cuts altogether; however, this development should not significantly impact the bond market, as the proposed tax cut would have accounted for only 4.4% of the bill’s total tax reduction, and the energy subsidy bill remains untouched. Financial market instability in the U.K. could continue given that the BoE’s asset purchases will end on Oct 14, which is to be followed by the government’s announcement of funding plans and BoE gilt selling later in the month.
Consecutive BoK rate hikes expected; high rate to intensify term spread reversal
While the Fed likely welcomes USD appreciation as the U.S. exports inflation, the BoK must manage KRW depreciation. Even with continuing inflationary concerns worldwide, the focus of central banks’ monetary policies is shifting toward responding to FX rates. For Korea, high inflation should linger because of strong demand and gas/electricity rate hikes taking effect in October. We initially predicted the year-end base rate at 3.25%, but we revised our forecast to 3.5% given that the weak KRW could force two 50bp rate hikes in October/November. For 2023, we see the base rate reaching 3.75%, but it may go as high as 4.00% if the Fed continues to tighten. We believe Korea will be unable to raise its rate as high as the U.S. given its high household debt-to-GDP ratio, which stands at 105%. However, BoK analyses indicate that recent rate hikes have had a considerable impact on slowing the increase in household debt and easing risk of financial imbalances, leading us to conclude that the BoK, as stated by Governor Rhee Chang-yong during the August MPC meeting, is focusing on inflation and financial stability while letting government support programs deal with the financial woes of low-income households. That said, higher-than-expected rate hikes and their prolongation would dampen the economy. The market has already anticipated significant rate hikes by the BoK, so short-term KTB yields are unlikely to rise substantially, but long-term KTB yields may receive downward pressure from the economic burden created by rate hikes. As a result, the term spread reversal between 3y KTBs and 10y KTBs should worsen and persist for a considerable time.