The author is an analyst at NH Investment & Securities. He can be reached at [email protected] — Ed.
Despite concerns about the recession, the euro zone and the United Kingdom are joining the procession of key rate hikes to control inflation. This new global central bank standard must result in a further inversion of the global TB yield curve.
The new central bank standard
Amid pervasive war concerns in the region, the Eurozone unanimously raised its base rate by 75bps to ease inflationary pressures while hinting at the possibility of further, bigger hikes. Meanwhile, the UK, which is experiencing a spike in gas prices, is expected to rise more than 50 basis points at the next meeting in September. In short, the euro zone and the United Kingdom are joining the procession of key rate hikes despite concerns about the recession.
Since the Jackson Hole Symposium, the norm for major central banks has been to maintain a firm tightening policy until inflation is brought under control, regardless of economic indicators. To prevent the TB market from preemptively pricing in a slower tightening, central banks will not ease based solely on signals of an inflation spike. The August US CPI, to be released this week, is expected to come in lower than July’s figure, but that doesn’t mean the Fed’s tightening will ease.
Note that the US BEI 10yr-2yr spread, which had remained inverted since the beginning of 2021, has remained in positive territory since September. Reflecting the desire of MD central banks to control inflation, the US TB market predicts that inflation problems in the US will eventually be resolved. Compared to June, when the 10-year TB yield last peaked, inflation concerns have eased, but worries about the global slowdown have increased. As such, we believe long-term TB returns should not exceed their previous highs. We believe the 10yr TB yield is attractively valued and expect the 10yr-2yr reversal to deepen.
Exchange rates soar, but the price of oil converted into won falls
The US$/won exchange rate has soared above the 1380W mark, but we are open to the possibility of a further increase. As Governor Lee Chang-yong mentioned, the level of the exchange rate itself is not a problem. On the contrary, the key is the possibility of an increase in the import price index. Fortunately, oil prices have fallen since the end of August, pushing down the price of WTI converted into won. Although the US dollar’s surge against the won is worrisome, the resulting inflationary pressures should be less than those seen in June.
In our opinion, the BOK has no choice but to follow the new central bank standard. As such, we expect the BOK to rise by 25 basis points at every meeting until the end of the year. However, domestic inflation is expected to be similar to that of the United States rather than that of the euro zone, with Korea remaining among the countries most vulnerable to the global economic slowdown. With the KTB market already pricing a terminal benchmark rate of 3.25-3.50%, long-term yields will likely stabilize lower for now.