Fixed income strategy
The author is an analyst of Shinhan Securities. He can be reached at jk.ahn@shinhan.com -- Ed.
Rate freeze likely in April given declining external uncertainties and slowing inflation and growth
The Bank of Korea (BOK) is expected to make a unanimous decision to leave the base rate unchanged at 3.50% at the April Monetary Policy Board (MPB) meeting. External conditions have changed since the February MPB meeting, with the US Fed’s terminal rate forecast at 5.25% after the March FOMC meeting. In the domestic market, inflation has continued on a downtrend. The March Consumer Price Index (CPI) rose 4.2% YoY, marking the slowest increase since March last year. The contribution of goods prices to CPI growth has been on a steady decrease, bringing inflation down. The contribution of service prices remains high in the 2%p range, but inflation will likely continue its downward trajectory. With external uncertainties declining and inflation stabilizing at lower levels, we expect the BOK to opt for a rate freeze in April.
We also need to consider domestic economic conditions. Exports dropped 13.6% YoY to USD55.12bn in March, continuing negative growth for a sixth straight month. Consumption slowed with credit card transactions falling for a second consecutive month to KRW87.5tr in February. Looking at production, manufacturing and services continued to weaken in 1Q23. In particular, construction investment showed a sharp contraction amid worsening consumption and investment. All of which lend support to a rate freeze.
The BOK should shift its focus to the domestic economy from April onwards, amid the slight easing of external headwinds. The economy is in worse shape than originally thought. The central bank is expected to keep the base rate unchanged at 3.50% at its upcoming rate-setting meeting. The decision is highly likely to be unanimous this time, unlike in February when views were divided on the course of inflation. We do not expect much of a disagreement among the board members with March CPI growth down to the 4% level, but should remain open to raising the rate to 3.75% down the road.
Short-term yield curve to steepen, BUY when 3Y KTB yield nears 3.40%
Yield curves will likely return to normal around the April MPB meeting. A rate freeze decision should place upward pressure on KTBs with maturity of less than five years. The decline in mid/long-term bond yields should be partially limited as tax revenue shortfalls raise concerns over the possibility of increased KTB issuance in 2Q23. The rate of government tax collection to the annual target stood at 13.5% in February, lower than 17.7% a year ago and the past five-year average of 16.9%. The government’s tax revenue is forecast to continue its downtrend with falling contribution from income and value-added tax collection. In 2Q23, the government is projected to issue more bonds than a year ago (KRW51.2tr) to fill in for the lack of tax revenue. We expect to see an increase in the issuance of medium-term bonds of five to ten years and a steepening of the short-term yield curve. A buying opportunity should emerge when the 3Y KTB yield nears 3.40%.