Fixed income strategy
The author is an analyst for Shinhan Securities. He can be reached at jk.ahn@shinhan.com -- Ed.
Lowered expectations for US rate cuts, strong external headwinds for 3Q23
US Treasury yields are unlikely to move lower in 3Q. The Silicon Valley Bank crisis and the ensuing financial market unrest that triggered the drop in bond yields since March have eased. And recently, there is a possibility of the US Fed sticking to its tightening cycle for a while yet. Concerns are high that 2Y and 10Y US Treasury yields could rise temporarily above 5% and 4% levels, respectively, in early 3Q. We expect the 10Y yield to reach its peak (4.25%) within a year.
In the US, inflation is stabilizing at lower levels after a surge driven by strong demand and supply chain disruptions. Aggregate demand is highly likely to slow. However, the inflow of funds into the country and steady government spending on infrastructure and others are moving the inflation target of 2% out of reach. We believe additional demand-suppressing measures are needed now to bring down inflation. Even without raising interest rates further, the Fed may have to keep to the dot plot projection and maintain its hawkish stance for a considerable period of time, at least until the September FOMC meeting. The domestic bond market could face heightened external volatility in 3Q as a result.
Conservative approach needed with KTB yields likely to rise higher
We recommend taking a conservative approach to the domestic bond market as KTB yields could rise higher in July. We are seeing decreased buying activity from domestic institutional investors amid reduced expectations for a rate cut within the remainder of the year. Foreign investors’ buying will not be strong given weakening arbitrage opportunity. Adding to lackluster market demand, KTB yields may face temporary upward pressure from volatile external bond yields. We suggest the upper bound of the 3Y KTB yield at 3.90% and that of 10Y KTB yield at 4.00% until the July FOMC meeting. The yield curve should bear-steepen with long-term bond yields continuing to rise this month on robust economic conditions at home and abroad and stubbornly high core inflation.
Factors that will bring bond yields down going forward are: 1) easing upward pressure on external yields; 2) 2Q domestic GDP growth of less than 0.3% QoQ; and 3) increase in credit issues. For these factors to play out in the market, the Fed funds rate should not exceed 6% and Korea’s annual GDP growth outlook has to be lower than 1.4%, which would be confirmed at end-July at the earliest. We forecast the federal funds rate to peak at 5.50% and the Korean economy to grow by about 1% in 2023. Yields on major KTBs may rise close to YTD highs, but only temporarily. With KTB prices at attractive levels, bottom-fishing opportunities will likely emerge upon the removal of uncertainties over the US policy rate and domestic GDP growth at the end of the month.