Market starts to think about 2024
The author is in analyst for NH Investment & Securities. He can be reached at sw.kang@nhqv.com -- Ed.
The recent high volatility in market rates is being driven by fluctuations in 2024 rate cut expectations, rather than the terminal rate. This is evidence that the market has started to reflect 2024 macro conditions. Currently, 10yr yields reflect a 2024 neutral level of 3.5%. Market rates are likely to stabilize further.
Market starts to think about 2024
After rising above 4% in early July, US 10yr yield fell back to 3.83%, as bargain hunting quickly took hold after June CPI came in below expectations. We note that: 1) housing costs fell for a third consecutive month; 2) core services inflation (excluding housing) slid for a ninth consecutive month; and 3) used car prices also declined. In our view, the recent drop in US inflation is not only related to base effect from energy prices. Although the trajectory of inflation stabilization may zigzag through yearend, our expectation remains that the July "insurance rate hike" will be the last hike of the current cycle.
Notably, the terminal rate forecast, as reflected in the swaps market, remains at 5.5%, despite the high market rate volatility that preceded and followed the rate announcement. Historically, the terminal rate has been the main driver of rate increases. However, this time around, 2024 cuts are the main driver of the market. This suggests that the market's focus is shifting from ‘higher’ to ‘longer’, and it is evidence that the market is starting to reflect macro conditions in 2024.
From a strategy perspective, it is too early to have confidence in the 2024 economic environment. For now, a market outperformance strategy is targeting the convergence of yields to a neutral level reflecting the 2024 cycle. Given the current r* and price levels, we estimate the current neutral level of 10yr yields to be 3.5%. We expect market rates to stabilize further.
Korea-US rate reversal is not the star of the show
Some corners of the market still argue that if two Fed rate hikes become a reality, the BOK will make further hikes. This stems from the governor’s assessment at the last inflation review meeting that one Fed hike has already been factored in, but two hikes would be new information.
However, the statement does not mean that the BOK will immediately respond with rate hikes. Since Oct 2022, the Korea-US policy rate differential has widened by 175bp (reflecting the July Fed hike), but the dollar/won rate has plunged by about US$/W174 from US$/W1,440 to US$/W1,266 during the same period. Expectations that the Fed's rate hike cycle has end are more important than the Korean-US policy rate differential. In other words, from a monetary policy perspective, the policy rate differential is not the star of the show right now. We maintain our view that Korea’s rate hike cycle has ended.