Brace for Volatile Yields
The author is a fixed income strategist of Shinhan Investment Corp. He can be reached at jk.ahn@shinhan.com. -- Ed.
Base rates at neutral levels but central banks remain hawkish on inflation
The Bank of Korea (BOK) and the US Fed are standing firmer than ever on their hawkish stance even with base rates reaching or even exceeding neutral levels, in efforts to stabilize inflation expectations and prevent entrenched inflation. The central banks aim to lower inflation expectations by dashing market hopes that had been rising from July for an end to rate hikes this year and a shift to rate cuts next year. We believe it unwise to attempt fighting the central banks as they continue to hold a firm stance on inflation.
Brace for volatile yields on rise in monetary policy uncertainties
Base rate projections for the BOK hinge on the Fed’s monetary policy, which is linked to the US inflation outlook. Inflation in the US is expected to stabilize in 4Q22, backed by easing labor costs, slowdown in food/beverage price hikes and steadier energy prices. If the August consumer price index (CPI) registers a 0.2% or lower increase on a MoM basis, we expect the upper bound of the US Fed funds rate at the year's end to reach 3.75% (Scenario 1). If the August CPI growth comes in at or above 0.3% MoM, the year-end Fed funds rate may reach as high as 4.00% (Scenario 2). Then, the BOK base rate forecast for end-2022 would increase from 2.75% to 3.00%. Moreover, in case of Scenario 2, the BOK rate hike cycle could continue through January 2023, pointing to expectations for an actual peak at 3.25% above the end-2022 forecast of 3.00%.
For September, we suggest a yield band of 3.40-3.80% for 3Y KTBs and 3.45-3.80% for 10Y KTBs, with the 3Y-10Y yield spread in the 2-8bp range. Investors will need to brace for volatile markets in the near term, with bond yields in the domestic market to fluctuate on rising caution as US Treasury yields face heightened intraday volatility ahead of the Fed's FOMC meeting in late September. We recommend taking a conservative approach on the assumption that 3Y KTB yields could rise above the YTD peak to 3.80% ahead of the September FOMC meeting.