MNI ANALYSIS: Tactical Korean Won Weakness Has Further To Run

--USDKRW 10% Loss Seen As Increasingly Likely

By Stuart Allsopp

     SINGAPORE (MNI) - The Korean won has performed well over the past 12

months, with its 4% gain against the U.S. dollar making it one of the best

performing currencies in the world, having held its own during the recent

emerging market FX rout. The country's relatively strong economic fundamentals

compared to the US -- faster real GDP growth, lower inflation, strong current

account surplus, superior fiscal accounts - are no doubt supportive of the won

from a fundamental perspective. 

     However, the increasingly wide interest rate differential spread between

the US and Korea suggests that the won should be trading roughly 10% weaker and

MNI expect this weakness to play out over the second half of the year.

--REAL YIELD SPREADS INCREASINGLY WON NEGATIVE

     The current nominal 2-year yield spread between the US and Korea is 54bps

in the US's favour, having moved from roughly -23bps 12 months ago.

     Real yield spreads, calculated by deflating 2-year nominal yields by

medium-term breakeven inflation expectations (using 5-year breakevens in the US

and 8-years in Korea, the only tenor available), are currently 64bps in Korea's

favour, but this figure has moved from 131bps 12 months ago. The 4% rally has

come in spite of this considerable shift in real yields in the dollar's favour.

--REDUCED RISK SPREADS DO NOT JUSTIFY STRENGTH

     One factor which explains some of the won's strength has been the decline

in default risk, with the 5-year CDS spread falling roughly 20bps over this

period thanks to still-strong risk appetite in credit markets generally and

Korea's ongoing sovereign improvement. 

     That said, even factoring in the reduction in the CDS spread,

'risk-adjusted' real yield spreads have still moved in the US's favour over the

past 12 months.

--WON REMAINS 10% OVERVALUED

     When we look at the correlation between USDKRW and risk-adjust real yield

spreads (see chart), there is still a huge gap between the two. Over the past

10-years the correlation has been as high as 0.74 and in the 9-year period prior

to the past 12 months the figure is even higher at 0.83. Based on this

correlation we estimate USDKRW should be trading at around 1,180, almost 10%

above current levels.

     There are two risks to this view. Firstly, that this divergence remains in

place, and secondly, that the gap closes not by won weakness but by

risk-adjusted real yield spreads moving in the won's favour, but neither of

these seem particularly convincing.

     Regarding the first point, it could be argued that the U.S. dollar requires

some discount due to the shift in the U.S. leadership's policy towards favouring

a weaker dollar, something which President Trump has often spoken about.

However, given the independence of the Fed the executive's wishes for a weaker

dollar are unlikely to manifest. Besides, the dollar's yield advantage is

already causing dollar strength against most of the world's currencies, so the

won's resilience appears more of a won story than a dollar story.

     Regarding the second point, there is very little room for reduced credit

default risk to support the won given how low CDS spreads already are, so a

reversal in the Fed's hiking cycle or a marked hawkish shift by the Bank of

Korea would be needed to justify the won's strength. While the former is a

possibility, it would likely only occur if we saw a sharp reversal in real GDP

growth and inflation expectations, in which case real yields would not

necessarily decline much if at all. Regarding the latter, BOK Governor Lee

Ju-yeol stated last week that there is little reason to be optimistic about the

economy, citing weakness in the labour market, and a hike at the May 24 meeting

looks highly unlikely.

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

--MNI London Bureau; tel: +44 203-586-2225; email: les.commons@marketnews.com

[TOPICS: M$A$$$,M$U$$$,MN$FX$]