Interest Rate Gap is Widening between US and S. Korea

The government bond yield is continuing to fall and about to fall below 2%. This has to do with the ongoing trade war between the U.S. and China and South Korea’s deteriorating economic conditions. Besides, successive U.S. interest rate hikes are causing an increase in interest rate spread, adding to the likelihood of capital outflow.

According to the Korea Financial Investment Association on August 12, the three-year government bond yield fell approximately 8.3 basis points on August 10 from the previous day and reached 2.040%, hitting this year’s low again after July 11. The rate exceeded 2% in October last year but is about to fall below 2% in just 10 months. Under the circumstances, market participants are expressing concerns over a super-low interest rate situation.

Recently, South Korea’s government bond yield showed a limited increase in spite of rising interest rates in major countries such as the U.S. and Japan. This is mainly because of a delay in benchmark rate adjustment by the Bank of Korea. “The consumer prices need to be close to the central bank’s inflation target and economic conditions need to be favorable for any key rate increase, but South Korea’s economic indices are currently negative,” said a local securities company, adding, “The year-on-year consumer price increase stood at 1.5% and job market situations were not favorable last month, hindering a key rate increase.” In the second quarter of this year, the growth of the South Korean economy stood at 0.7% quarter on quarter amid a substantial decline in capital expenditure, which means an economic slowdown in the second half is highly likely.

The decline in interest rate is beneficial for companies and households in need of a loan. However, it can lead to capital outflow from the local stock market at the same time. Especially, current predictions about another interest rate hike by the Fed are quite burdensome for South Korea. The 10-year government bond yield spread between the U.S. and South Korea, which was 30 basis points early this year, reached 43 basis points on July 25, close to the all-time high of 45 basis points recorded in December 2016.

The market consensus is that the Bank of Korea will not raise its key rate this month. However, the central bank needs to do so at least once this year in order to avoid foreign capital outflow attributable to interest rate decoupling. Still, it is already reflected in local market interest rates and, as such, an increase in market interest rate resulting from the key rate increase is likely to be rather limited.