The author is an analyst of NH Investment & Securities. He can be reached at firstname.lastname@example.org. -- Ed.
While concerns over a slowdown in the real economy are mounting, short-term funding stress has eased. As a result, market demand will likely shift from cash to government bonds, and US TB yields should stabilize downward. A likely stabilizing in foreign selloffs of KTBs is to lead to drops in long-term yields.
Stabilized RP markets to push up demand for US TBs
It is necessary to distinguish the risks to which individual asset classes are responsive. The current downturn in the market is attributable to woes in the real economy stemming from the Covid-19 outbreak. In times of trouble in the real economy, safe assets are inevitably preferred over risky assets. Early last week, however, even US TBs were subject to dumping, upsetting their status as safe assets. The cause of such was cash needs amid sudden financial stress early last week. RP interest bid yields soared to 2% during trading hours, highlighting concerns over a possible freeze in short-term funding. As a result, even US TBs faced a sell off amid the amplified importance of securing US dollars.
That said, tight money market fears can be fully tackled via aggressive monetary policies. Just last week alone, the Fed bought up 62.4% of the US TB QE target of US$500bn?by Mar 23, the figure should reach 77.4%. Considering that it is difficult to avoid QE due to the deteriorating economic conditions, we expect to see an increase in the size of the US’s QE operations. In addition, the Fed has already announced that it will expand its daily RP liquidity operation to US$1tn.
The Fed’s aggressive response has stabilized RP interest yields within the range of the FF rate since Mar 19. The bid-ask spread, which has jumped up 6.4x compared to the February average, also quickly reduced to the early-March level. The 10y US TB yield plunged by 30bp in just one day on Mar 20, as the US TB market recovered its status as a safe asset amid eased concerns over a tight market for short-term funds. Accordingly, we expect market demand to shift from cash to US TBs. With recent credit market risks arising in US being likely to spur appetite for US TBs, we believe that 10y US TB yields will fall to their previous lows. Against this backdrop, we continue to suggest going long on long-term US TBs.
KTB’s status as safe asset to also restore
The pace of foreign selloff in the won-denominated bond market should also slow in response to the stabilization of the US short-term funding market. Moving ahead, we expect market attention to shift back to economic conditions and prices.
The spread between the benchmark interest rate and 10y KTB yield has expanded to 88bp, a level reflecting a rate hike. Given both the rocky economic landscape and the status (reaffirmed since 2016) of KTBs as a safe asset, we view the recent spike in yields as being somewhat excessive. Moreover, we point out that the BOK is to make at least W5tn worth of KTB purchases year, reducing the supply burden from the stimulus package. Given the current economic and supply-demand conditions, we advise utilizing the current upsurge in long-term KTB yields (stemming from the foreign selloff) as a good buying opportunity.