South Korea to hike rates in 4Q, first in Asia

Acceleration of vaccination and the pace of economic recovery have raised prospects of policy normalisation to resume in late-2021.
Ma Tieying, Duncan Tan28 Jun 2021
  • Rate hikes will likely come earlier than expected, while the pace would remain gradual
  • We now expect the BOK to raise the benchmark rate from 0.50% to 0.75% in 4Q21, ...
  • … and to 1.25% by end-2022
  • Markets’ pricing of hikes over the next 12 months appears overly aggressive
Photo credit: AFP Photo

Mass vaccination and economic recovery

The COVID-19 vaccination in South Korea has started to gather pace, thanks to the easing of supply shortage and the increase in public trust. The share of population that received at least one dose of vaccines rose to 29% in the fourth week of June, notably higher than 11% in end-May and 6% in end-April. If the current pace is sustained, vaccination rate will likely exceed 50% in August and 70% in September.

As the vaccination rate increases, social distancing rules are gradually relaxed. The government has decided to allow the semi-vaccinated people to engage in larger family gatherings from June and to go outdoors without wearing masks from July. It plans to further relax social distancing rules later this year, enabling people to have a “safe and comfortable” summer vacation and to gather with family without wearing masks during the Chuseok holiday in autumn. 

The prospect of a fuller and broader economic recovery is improving. Google mobility data show that retail and recreation activities have returned to the pre-pandemic normal levels in May and risen further in June. In the labor market, jobless rate slipped to 3.8% sa in May, closer to the pre-pandemic level of 3.6% seen in 4Q19; labor participation rate rose to 63% sa, also approaching the 63.5% in 4Q19. A fuller recovery in the labor market could be seen by the year end, as economic activities further normalise and the output gap turns positive.

Shift in policy priority

Mass vaccination and a fuller recovery will likely provide the needed conditions for the Bank of Korea (BOK) to normalise monetary policy, shifting the priority from supporting growth to safeguarding price and financial stability.

Inflation is already rising faster than expected, exerting pressure on the BOK. Headline CPI jumped to 2.6% YoY in May, above the BOK’s 2% target for the second month in a row, and the highest reading over nine years. Consumers’ expected inflation rate for the next one year also climbed above 2%, reaching 2.2% in May. Given the ongoing price momentum and the rise in inflation expectations, CPI numbers are likely to stay above the 2% mark in 3Q and retreat only slightly to 1.5-2% in 4Q.

The rapid rise in property prices and household borrowings also puts pressure on the BOK. Notwithstanding the government’s tightening of tax measures, residential property prices continued to surge 13% YoY in May, the fastest pace over 18 years. Banks’ household loans registered double digit growth for the tenth consecutive month in May, at 11% YoY. As debt growth continues to outpace nominal GDP, household debt to GDP ratio is likely to rise to a new record high of 110% by the end of this year.

Timing and pace of rate hikes

There are clear signals from the BOK that rate hikes will come earlier than expected. Governor Lee Ju-yeol flagged the possibility of rate hikes on June 11, saying that the current accommodative policy should be normalised “in an orderly manner at an appropriate time”. He sent a stronger signal on June 24, explicitly saying that rate normalisation will come at “an appropriate time by the end of the year”.

The pace of rate hikes will likely remain gradual, based on historical experience. During the policy normalisation cycles in the past two decades, the BOK delivered 50-75bps hikes per year in 2005-07 and 2010-11, and 25bps hike per year in 2017-18. Notably, the neutral rate level has drifted lower in the recent decade, as a result of the structural decline in GDP growth and inflation. 

We now expect the BOK to start to raise rates in 4Q, and deliver 25-50bps hikes per year during the upcoming cycle. The benchmark repo rate is expected to be lifted to 0.75% by the end of this year, and further to 1.00% by mid-2022 and 1.25% by end-2022 (reverting to the pre-pandemic level seen in Dec19).

Implications for KRW rates

Onshore KRW IRS markets are pricing for a frontloaded BOK hike cycle - 100bps of hikes over the next twelve months. If market expectations were to materialize, we would see the policy rate rise from the current 0.50% to 1.50% by mid-2022, and subsequently plateau at around 1.75%. Relative to our forecast, the pace of priced hikes over the next 12 months certainly appears aggressive. However, considering that we are approaching the start of the hike cycle, coupled with BOK's incrementally hawkish communications, we think that hike pricing can stay elevated and even overshoot in the near term (immediate 2-3 months). Further out, we expect market expectations to shift towards our forecast for a more gradual path of rate hikes, and therefore, there is likely scope for 2Y to 5Y IRS curve segment to steepen ahead.

Current 10Y Korean Treasury Bond (KTB) yields are already well-priced for South Korea's strong growth recovery, continued heavy KTB supply and BOK's earlier-than-peers liftoff (expected). In 2H, we expect 10Y KTB yields to still be biased higher and see scope for a 20-30bps rise, largely as a beta move against our expectations of higher 10Y US Treasury yields.

From a total returns perspective, equity outflows by both foreigners and locals continue to weigh on KTBs’ returns outlook. Stock outflows by foreigners have been large year-to-date, particularly in May. Locals have also significantly stepped up their purchase of overseas stocks in recent quarters, though we are seeing some moderation in 2Q based on Korea Securities Depository data.

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Ma Tieying 馬鐵英, CFA

Economist - Japan, South Korea, & Taiwan 經濟學家 - 日本, 南韓及台灣

Duncan Tan

FX and Rates Strategist - Asean
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