REPEAT: MNI ANALYSYS: Korean Won At Risk As Asian FX Weakens

Repeats Story Initially Transmitted at 15:35 GMT May 2/11:35 EST May 2

--Real Yield Differentials Suggest USDKRW Should Be Much Higher

By Stuart Allsopp

     SINGAPORE (MNI) - MNI continues to anticipate a broad-based weakening of

Asian FX as interest rate differentials turn increasingly in the U.S. dollar's

favour. While in most cases Asian currencies still yield more than the USD,

their carry advantage has diminished greatly following the rise in the Fed Funds

rate. Crucially, the same is true in real terms as U.S. trailing CPI and

breakeven inflation expectations have not risen as fast as interest rates.

--U.S. REAL YIELDS SURGING

     When calculating real yield spreads MNI prefer to use breakeven inflation

expectations rather than trailing CPI, as they give a more accurate picture of

the future outlook for inflation compared with trailing CPI. Based on this, the

spread of U.S. 2-year bond yields less 5-year breakeven inflation expectations

currently sits at 40bps, having risen markedly from around -200bps back in 2013.

Monetary policy has tightened dramatically, which should lead to an increase in

demand for dollars over the medium terms as investors seek higher real returns.

--KOREAN WON AT RISK

     Most Asian economies do not have inflation-linked bonds and so breakeven

inflation expectations are not available, but South Korea is a notable

exception. South Korea has inflation-linked bonds maturing in 2026, from which

inflation expectations are calculated at 87bps. If we take the spread of 2-year

Korean interest rates swaps less 8-year inflation expectations, the figure

currently stands at 115bps.

     Taking the spread of U.S. over Korean real yields, the figure is currently

-75bps as Korean real yields are still higher thanks to much lower long-term

inflation expectations, which are largely justified by Korea's superior fiscal

position. However, what matters for currency performance is not the absolute

level of real yields but the change. Over the past four years, U.S. real yields

have moved significantly in the greenback's favour. As one would expect, moves

higher in U.S. real yields relative to Korea's have been negative for the won,

although this correlation has recently broken down.

     Another factor to take into account is the fact that Korean assets have a

higher default risk premium, particularly at times of global risk aversion. If

we incorporate 5-year credit default swap spreads into the equation, by

subtracting it from Korean real yields to arrive at default risk-adjusted real

yields, the correlation with USDKRW improves further. While there is virtually

no default risk in investing in Korean local currency assets given that the

central bank can create won at will, rising default risk on Korean Eurobonds

still tends to undermine the won, as investors tend to shed Korean assets across

the board during times of heightened default risk.

--USDKRW: 10% BELOW 'FAIR VALUE'

     After adjusting for default risk there is a much tighter correlation

between USDKRW and real yield spreads, and the current spread suggests that

USDKRW should be around 1,190. A move back to this level would represent a 10%

rally for the dollar.

--MAIN THREAT RISING RISK AVERSION 

     An additional risk comes from the fact that default risk is very low

historically and has the potential to rise in the event that global credit

stresses begin to emerge. While MNI do not see this as imminent, such a move

could be triggered by anything from a trade war, continued U.S. monetary

tightening, or a renewed downturn in U.S. stocks. With this in mind, the

risk-reward outlook for USDKRW is looking increasingly positive for the dollar.

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

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