For something that cannot be directly observed, and changes through time, the neutral level of interest rates generates an awful lot of debate, says Strategist Russell Silberston.
26 May 2022
When allocating capital to government bonds with a medium-term horizon we believe it’s best to focus on defensive markets that are facing structural headwinds to growth and inflation and should therefore see yields biased lower through time as monetary policy progressively adjusts to support the economy.
South Korea is one such economy, in our view; it faces structural challenges which threaten to lower the nation’s nominal growth rate and deliver deflationary domestic forces. These range from demographics, with the country’s birth rate falling below Japan, to household debt, with Korean households in a leveraging cycle since the 1990s. As Korea’s population ages further and moves into decline it is increasingly likely that the economy will shift from a leveraging to a deleveraging cycle, placing downward pressure on both growth and inflation.
On the cyclical side, we believe that the drivers which have supported policy tightening are now beginning to turn. One of the key drivers of demand over the past 18 months has been the strong external backdrop, however, the impact of higher prices on real incomes globally, as well as the weakness in China from tightening credit and renewed covid restrictions, are beginning to filter in to demand for Korean exports where recent readings have pointed to a slowing. Indeed, recent domestic data has also begun to slow, reflected in the Korean government’s leading indicator for growth.
The Bank of Korea has a struck a balanced tone, highlighting the need for a further removal in policy accommodation to ensure inflation remains well anchored, while noting that any weakness in growth could lead the Bank to act more cautiously. Indeed, recent comments from the governor noted there is a “trade-off” between inflation and economic growth which reduces the central bank’s room to manoeuvre, and as a result it is his belief that policy rates will not have to be taken to restrictive levels as slowing growth is likely to put a ceiling on inflation pressures.
Against this backdrop, we expect the level to which policy rates can rise without causing a significant growth slowdown remains low. We currently believe that this level is around 1.5-2.0%, compared to a current policy rate of 1.5%, with it likely to decline further in the future as potential growth declines. Despite this and the recent cyclical slowdown being evident, the bond market is pricing policy rates significantly above this level, with market expectations for rates to be hiked by a further 1.5% over the next 12 months to 3.0% and expected to average above this level for the next 10 years.
We believe this environment creates an opportunity for capital appreciation as fewer rate hikes are likely to be implemented relative to expectations, whilst also providing investors with a significant income buffer given elevated rate expectations and a high absolute level of yields. As a result of this aligning of structural and cyclical factors, coupled with attractive valuation, carry and roll, we believe Korean bonds present an attractive asset to invest in.
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