Bond Market Clashes With Hawkish Bank of Korea Over Rate Pricing

South Korean bond investors appear to be betting against the central bank -- which is rarely a good position to be in. 

Swap markets have been dialing back the odds of future Bank of Korea interest-rate increases as the spread of virus cases boosts the prospect of an economic lockdown. At the same time, Governor Lee Ju-Yeol has been sounding ever more hawkish, signaling in July that even two hikes would still leave policy accommodative. 

The market is now pricing in barely 25 basis points of rate increases by year-end, down from around 40 at the end of last month. At the same time, the odds of a move at this Thursday’s BOK meeting have dropped to around 50% -- effectively a coin toss.

Bond Market Clashes With Hawkish Bank of Korea Over Rate Pricing

“While there’s growing doubt in the market, BOK has signaled a rate hike quite aggressively and if it ends up holding rates next week, nobody will believe them anymore,” said Kong Dongrak, fixed-income strategist at Daishin Securities Co. in Seoul.

Governor Lee ratcheted up his hawkish rhetoric at the central bank’s previous meeting on July 15, saying it’s time to discuss an adjustment to monetary easing. Then he went further, adding that even if policy makers raise rates once or twice, there would still be no change in the position, implying there’s room for even more tightening before reaching the neutral rate.

While the BOK left its benchmark at a record-low 0.5% last month, one board member called for a hike of a quarter percentage point. The reasons for hawkishness include an anxiety to rein in growing levels of household debt, a property bubble and other financial imbalances.

Bad News

If the central bank does raise its policy rate three times to 1.25%, which is the level it was at before the pandemic, that would be bad news for Korean shorter-maturity bonds. Three-year yields are currently at just 1.49%, leaving little left over for holders if the BOK raises its key rate by 75 basis points over that period.

Still, bond investors are far from convinced the BOK has the ability to deliver on a series of hikes that would drive yields higher.

“While the bet for an August hike is still in place, there’s now either the chance for the next hike to come much later, or for the BOK to cut back rates after raising them too quickly,” said Moon Hongcheol, a fixed-income and foreign-exchange strategist at DB Financial Investment Co. in Seoul. Despite the potential for near-term hikes, there’s more room for yields to edge lower in the second half, he said. 

Here are the key Asian economic data due this week:

Aug. 23Japan Preliminary Jibun Bank Japan PMI Mfg and Services
 Singapore July CPI YoY
Aug. 24New Zealand 2Q Retail Sales Ex Inflation
 Thailand July Customs Exports YoY
Aug. 25New Zealand July Trade Balance
 Malaysia July CPI YoY
Aug. 26Australia 2Q Private Capital Expenditure
 Singapore July Industrial Production SA MoM

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