[Click eStock] "Korean Fundamentals Slowdown... Largest Inversion of Long-term Interest Rates Between Korea and the US"

The inversion spread of long-term interest rates between Korea and the U.S. has reached an all-time high. After the U.S. implemented rate cuts, the inversion spread in benchmark interest rates between Korea and the U.S. narrowed from 200bp to 150bp, but the inversion spread in 10-year long-term interest rates actually widened from 120bp-130bp to 190bp, marking a record high.

On the 14th, Meritz Securities analyzed that the core reason for the deepening decoupling of market interest rates between Korea and the U.S. is based on a strong U.S. economy and the increasing pressure of weakening fundamentals in Korea relative to high inflation. However, they judged that if expectations for further expansion of monetary policy divergence between Korea and the U.S. are unlikely, the decoupling of long-term interest rates has also reached a critical threshold.

Yoon Yeo-sam, a researcher at Meritz Securities, predicted, "Considering financial stability factors such as the exchange rate, the inversion spread will gradually narrow in line with future policy expectation adjustments."

Meritz Securities, through its annual outlook published last October, forecasted that the U.S. would cut rates by about 100bp this year and Korea by about 75bp, narrowing the inversion spread to within 100bp with the U.S. federal funds rate at 3.5% and Korea’s benchmark rate at 2.5%.

By the end of last year, while Korea made a surprise rate cut in November, the U.S. saw reduced expectations for rate cuts this year due to favorable economic conditions. Meritz Securities adjusted its forecast, expecting the Korea-U.S. benchmark interest rate gap to remain around 150bp (U.S. 3.75% vs. Korea 2.25%).

Current market expectations hold that with the continued strength of the U.S. economy, the U.S. rate cut expectation is limited to one cut this year, resulting in a 4.25% rate, while domestically, due to difficult economic conditions, the dominant view is that rates will be cut to 2.25%.

If the current market consensus is reflected as is, the Korea-U.S. benchmark interest rates will revert to the previous maximum inversion spread of 200bp (U.S. 5.50% vs. Korea 3.50%) one year from now. At the upcoming January Monetary Policy Committee meeting this week, expectations for rate cuts domestically remain dominant. As monetary policy expectations are reflected in long-term market interest rates, the 10-year interest rate gap between Korea and the U.S. has deepened to a historic maximum of around 190bp, with Korean rates remaining lower, intensifying the inversion.

Since the first issuance of the 10-year Korean bond in October 2000, Korea and U.S. interest rates have mostly maintained a high correlation, but there have been about seven significant decoupling episodes. The main drivers of interest rate decoupling were differences in economic conditions between the U.S. and Korea. Korea experienced periods of economic downturn as well as relatively strong booms.

After the financial crisis, during a phase of weakening Korean economic momentum, there was a period in 2010 benefiting from China’s industrial upgrading, when Korea raised rates despite the U.S. maintaining zero rates. Except for such periods, most decoupling was driven by domestic economic slowdown. The intensified decoupling in the second half of 2024 is also interpreted as stemming from a strong U.S. economy but weak growth and inflation in Korea.

Comparing the consensus growth and inflation rates of the U.S. and Korea individually over the past three years shows that structurally, Korea’s economy and inflation have lagged behind the U.S. Of course, the U.S. benefited greatly from expansionary fiscal policy, while Korea’s balanced fiscal policy contributed to bond supply-demand issues, which also played a role in the inversion of interest rate spreads.

Until the third quarter of last year, expectations for growth and inflation in Korea and the U.S. for 2025 were relatively balanced. However, in the fourth quarter, political turmoil in Korea caused the growth forecast to drop from the low 2% range to recently 1.8%, while the U.S. expectation rose from about 1.7% to 2.1%.

Regarding inflation outlooks, the U.S., bolstered by recent strong employment, is worried about a rebound, whereas domestically, excluding exchange rate effects, inflation is expected to slow. In September last year, the U.S. cut rates by 100bp, while Korea only cut by 50bp, but the inversion spread, which had not expanded beyond 130bp before the cuts, widened to around 200bp.

Despite the narrowing of the Korea-U.S. benchmark interest rate inversion spread, if future monetary policy expectations are driving the inversion in long-term interest rate spreads, this has significant implications even during the recent won depreciation phase.

Although market interest rates are said to move ahead of monetary policy, during the period in 2023 when the Korea-U.S. benchmark interest rate inversion widened to 200bp, domestic rates closely followed U.S. rates. When the 10-year U.S. Treasury yield peaked near 5.0% in October 2023, the 10-year Korean bond yield followed up to 4.3%, keeping the inversion within 100bp. Notably, Korea’s growth rate was as low as 1.4% in 2023.

Fundamentally, the Korea-U.S. market interest rate inversion could have widened further in 2023, but importantly, high inflation at the time controlled expectations for monetary easing in both countries. Therefore, the forward-looking interest rate expectations for Korea and the U.S. were managed within 100-150bp. Recently, the deepening decoupling of monetary policy expectations between the U.S. and Korea has driven the expansion of the long-term interest rate inversion spread.

Many market participants emphasize that external interest rate differentials are highly sensitive to exchange rates, and the recent deepening of the Korea-U.S. market interest rate inversion is cited as a major factor behind won depreciation. However, a more precise analysis shows that the difference in expectations for benchmark interest rates one year ahead between Korea and the U.S. is a decisive variable for both long-term interest rate inversion and exchange rates.

While the U.S. is retreating from rate cuts, domestic rate cut expectations are expanding due to sluggish domestic demand, reflecting concerns that the Korea-U.S. benchmark interest rate gap could widen again to 200bp, which is priced into the won-dollar exchange rate at 1,470 won. This can be interpreted as the market already pricing in a 200bp Korea-U.S. benchmark rate gap, but conversely, if U.S. monetary policy expectations retreat while Korea maintains easing expectations, the exchange rate level could rise further.

To defend against further exchange rate increases (won depreciation), controlling domestic monetary policy expectations is necessary. Reflecting this, the forward rate, which at the beginning of the year priced in a benchmark rate of 2.0%, has sharply retreated and recently risen to around 2.5%.

Considering domestic growth and price stability, we forecast that a rate cut to 2.25% within the year is possible. However, if the U.S. rate cut is limited to 25bp or if rates remain on hold, there is a high likelihood that exchange rate surges will cause financial instability, constraining monetary policy.

Although major countries’ economic and inflation conditions differ compared to the U.S., the differentiation of 10-year interest rates among major countries in 2024 shows that self-reliance is intensifying. Even in advanced regions using reserve currencies, sensitivity to U.S. monetary policy is increasing, with a stronger tendency to follow the sharp rise in U.S. rates since December last year.

In 2023, it was difficult to find countries with strong economies among major countries outside the U.S., including Europe and China, and from 2024, even among major emerging markets. Nevertheless, the key variable gauging differences in absolute interest rate levels is inflation. Emerging markets in 2024 have seen sharp rate increases recently due to rising import prices amid a strong dollar phase.

In contrast, China, where long-term rates have recently fallen to the mid-1% range, shows the lowest inflation among major countries. Switzerland, an advanced country whose inflation fell below target levels last year, shows a similar pattern. Canada and Korea also have inflation stabilized around the 2% target, resulting in greater interest rate stability compared to the U.S.

With employment data confirmed in December, the U.S. economy faces increased risks of inflation rebounding, fueled by factors including "Trumpflation." Korea, caught between the U.S. and China economies, is explained by its interest rate levels and current inflation trends, but it is also in a phase where continuing decoupling from U.S. rates is difficult.

We are paying attention to the side effects that high U.S. rates may cause (fatigue from high rates). Since Trump’s inauguration, budget efficiency improvements leading to balanced fiscal policy, inducing a weaker dollar, and the possibility of monetary easing are seen as factors that could alleviate concerns about renewed tightening. It will take about one more quarter to confirm this. Meanwhile, we analyze that the Korea-U.S. interest rate decoupling has entered a critical threshold where further divergence is unlikely.

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