Looming Rate Cut, Foreign Inflows, Belie Weakness in Korea Bonds

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Huge foreign inflows into South Korean bonds belie returns that are among the lowest in Asia -- and an expected interest rate cut by the central bank may not be enough to change the picture anytime soon.

Despite a consumer price index that’s dropped below zero, most economists see the Bank of Korea standing pat after a likely reduction in benchmark borrowing costs on Wednesday.

While overseas investors in Korean bonds are boosting profits with exchange-rate hedging, local-currency returns on the nation’s debt rank near the bottom of 46 sovereign markets tracked by Bloomberg. Even with deepening disinflationary pressures, yields on 10-year Korean yields have fallen at half the pace of those for U.S. Treasuries this year.

Swaps suggest that the BOK will lower its policy rate twice from 1.5% in the coming year, adding to a reduction in July. That is less aggressive than the Federal Reserve, with overnight-index swaps pointing to at least two more cuts following two reductions so far this year.

“The U.S. typically moves in a wide range when it’s cutting or hiking rates while Bank of Korea looks like it’s walking on eggshells,” said Cho Yong-gu, a fixed-income strategist at Shinyoung Securities Co., citing the economy’s vulnerability to external shocks. “The BOK tends to be more conservative than others like the central banks of Australia and New Zealand.”

Korean debt may start to catch up with moves in Treasury yields early next year, but for now it is also being held up by an excess of supply, according to Lee Mi Seon, an analyst at Hana Financial Investment Co.

“The government plans to issue more bonds later this year and local funds seem reluctant to buy more debt as they’ve filled most of their allocations already,” she said. Spending plans for next year may see the government issue as much as 130.6 trillion won ($110 billion) in bonds.

To be sure, the central bank emphasizes that borrowing costs are already accommodative, and a 25 basis points cut would match a previous record low.

Even as the U.S.-China trade war weighs on Korean exports and inflation shows no signs of returning to the BOK’s 2% target, officials can point to signs that the situation will improve. The 0.4% drop in prices in September partly reflects the base impact of a spike last year, and the nation’s corporate champion, Samsung Electronics Co., reported earnings this month that beat estimates as demand picked up for smartphones.

“If an economic rebound is confirmed, October may end up as the last rate cut,” said Shinyoung Securities’ Cho.

Below are the key economic data and events due this week.

To contact the reporters on this story: Masaki Kondo in Singapore at mkondo3@bloomberg.net;Hooyeon Kim in Seoul at hkim592@bloomberg.net

To contact the editors responsible for this story: Tan Hwee Ann at hatan@bloomberg.net, Brett Miller

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