MNI ANALYSIS: Continued Korea Hike Cycle H2; At Measured Pace

By Stuart Allsopp

     SINGAPORE (MNI) - The Bank of Korea looks increasingly likely to hike rates

further over the course of 2018, with interest rate swap markets pricing in

25bps of hikes over the next 6 months. The chances have risen over recent days

following BOK Governor Lee Ju-yeol's comments on March 5 saying the central bank

should raise rates when it becomes possible to do so.

     South Korean news agency Yonhap reported Lee saying that financial

imbalances may increase should BOK maintain the current interest rate when

Korea's economy continues to grow at 3% and inflation consolidates at 2%. While

the BOK has tried backtracking, issuing a statement that Lee was speaking only

in general terms, the central bank clearly has a hawkish bias, and MNI expects

at least one 25bps hike over the remainder of the year.

     Technically, interest rate swaps remain on a bullish trend, with the

6-month tenor rising to a new 3-year high on May 8 at 1.755%. No real resistance

exists until 2.00%.

     --THREE DRIVERS

     Three main factors argue for higher rates over the coming months. 

     Firstly, oil prices continue to rise rapidly and given Korea's status as a

major net oil importer this will likely put upside pressure on import price

inflation. Brent crude oil prices are up 55% y/y and base effects almost

guarantee that the y/y price gain will increase in June and July.

     Secondly, as the gap between U.S. and Korea interest rates continues to

rise amid the Fed's tightening cycle, this should put downward pressure on the

Korean won, further increasing domestic price pressures. The won is roughly 8%

overvalued based on the historical correlation between real interest rate

differentials between the two countries.

     Thirdly, a global trade war would likely be an inflationary force, as it

would seriously dent export growth and likely trigger the government to engage

in increased fiscal stimulus to offset the impact on growth.

     Headline CPI came in at 1.6% y/y in April while core CPI came in at 1.4%

y/y. M3 money supply growth came in at 6.8% y/y in February, the latest data

available, which clearly shows the potential for fundamental inflation pressures

to rise.

     --HIKING CYCLE TO BE MILD 

     That said, we do not expect the interest rate hike cycle to be particularly

steep given that inflation expectations remain very low by historical

comparison. Based on the difference between the yield on regular government

bonds and inflation-linked bonds, breakeven inflation expectations over the next

8 years currently stand at just 0.85%. This is considerably lower than the 2%

rate that Governor Lee anticipates inflation to consolidate at.

     --REAL RATES REMAIN POSITIVE

     Even as inflation expectations are likely to rise amid higher oil prices,

there is little danger of real interest rates turning negative any time soon,

which could foster greater economic imbalances. Lee's comments about imbalances

were likely a reference to the country's excessive household debt burden.

However, household debt growth is slowing and while higher interest rates in the

past may have prevented the debt build-up, they risk exacerbating any

deleveraging cycle that takes hold.

     Aside from the high level of household debt, which is actually a

disinflationary force, the Korean economy is relatively well balanced, with the

external sector in solid shape and fiscal accounts reasonably healthy, despite

increased risks posed by President Moon Jae-in's Keynesian fiscal spending

plans. This should ensure that the BOK will be able to maintain a measures rate

hiking pace unless oil prices rise back towards USD100/bbl.

--MNI Singapore Bureau; +65 8233 2326; email: Asia-Editor@marketnews.com

[TOPICS: M$A$$$,M$$FI$]