US-Korea Base Interest Rates and Yield Curve Inversion Expected... Exchange Rate Ceiling at 1350 Won

Interest Rate Inversion Phenomenon, Exchange Rate Stimulus Factors
Won-Dollar Exchange Rate May Reach 1300 Won

[Image source=Yonhap News]

[Asia Economy Reporter Hwang Yoon-joo] Since July, there is a high possibility that the benchmark interest rates and government bond yields (short- and long-term yields) between South Korea and the United States will invert both domestically and internationally. The tightening measures by central banks, including the U.S. Federal Reserve (Fed), are fueling recession forecasts, leading to expectations that the won-dollar exchange rate could push its peak higher from the 1,300-won level.

Soyoyong, a researcher at Shinhan Bank, stated, "Due to rising expected inflation, the Fed is likely to implement a 75 basis points (1bp=0.01%) rate hike in July, and there is a considerable chance that the U.S. long- and short-term yields, based on the 10-year and 2-year bonds, will invert."

Researcher So added, "Another factor is that the Bank of Korea will also implement a 50 basis points rate hike focusing on curbing inflation approaching 6%, but it will allow inversion by the faster-moving Fed, resulting in an inversion of the interest rate differential between Korea and the U.S."

Typically, during periods of inversion in the U.S. long- and short-term yield spread triggered by the Fed's monetary tightening, the dollar has generally strengthened. Also, during the 2018-2019 period when the Korea-U.S. benchmark interest rates inverted, the dollar-won exchange rate showed an upward trend. This leaves room for further increases in the won exchange rate, which is already highly sensitive around the 1,300-won level.

[Image source=Yonhap News]

Researcher So explained, "The inversion of the U.S. long- and short-term yield spread is underpinned by a long-term yield response that seems different from the first half of the year," adding, "The 10-year market yield surged sharply to around 3.5% at one point, reflecting rapid inflation and concerns over the Fed's aggressive monetary tightening, but it has since fallen to about 3.0%."

He evaluated, "Although it is still premature to say that market yields have shifted to a downward trend, recently there have been noticeable movements focusing on longer periods, reflecting the Fed's nearing end of rate hikes and the risk of economic downturn."

He further diagnosed, "Concerns about capital outflows and the resulting exchange rate increases remain significant, but considering that the U.S. already maintains uniquely high benchmark interest rates among developed countries, and that Korea's inflation rate is relatively lower compared to the consumption-focused U.S., as well as the potential impact on domestic demand such as real estate, these factors will be taken into account."

Therefore, he predicted, "Even if the Bank of Korea raises rates to 3.0% by the end of the year, it is expected to tolerate some degree of inversion as it will remain below the Fed's anticipated 3.5%."

Researcher So pointed out that this inversion of interest rates is a factor driving the exchange rate higher. However, he expects it will not directly trigger large-scale capital outflows or a sharp rise in the exchange rate.

Researcher So emphasized, "If the inversion of the U.S. long- and short-term yield spread raises credit risk linked to a recession, the relative attractiveness of U.S. dollar assets due to higher relative interest rates could act as a catalyst for the exchange rate to settle above 1,300 won, so caution is necessary." In other words, it is not the inversion itself but the economic downturn and ripple effects embedded within it that will make the exchange rate more sensitive.

He pointed out, "The combination of high inflation, high interest rates, and high debt is more likely to pressure stagflation and deleveraging. Even if these are not immediately apparent, financial markets may preemptively and sharply reflect these risks."

He added, "From this perspective, Shinhan Bank recommends keeping the upper bound of the exchange rate open up to 1,350 won in its second-half outlook report and responding to manage upside risks."

This content was produced with the assistance of AI translation services.