"The Flames Are Out": What Lies Ahead for the Government Bond Market

Bond Market Risks Persist Despite Easing Oil Prices

Focus on Four Key Risks: Energy, Exchange Rate, Inflation, and Policy

Lower Bound for Government Bond Yields Raised

"The flames have been contained, but the heat remains." This is the assessment from the securities industry regarding the domestic bond market, which has fluctuated following the military clash between the United States and Iran. While tensions originating in the Middle East are showing some signs of easing and the surge in oil prices has subsided, concerns persist over macroeconomic variables that directly affect the bond market. Analysts point out that with the lower bound for government bond yields having shifted upward, any escalation of these risks could further increase upward pressure on yields in the future.

On March 5, Myoungsil Kim, a researcher at iM Securities, highlighted four key risks to watch in a report titled "The Flames Are Out, but the Heat Remains: The Invisible Variables Creating Downside Rigidity in the Government Bond Market." The risks specified were: ▲ energy, ▲ exchange rate and capital outflows, ▲ inflation trajectory, and ▲ policy.

Following the U.S. airstrike on Iran, the yields of 3-year and 10-year Korean Treasury bonds in the Seoul bond market have continued to rise, with closing yields on the previous day returning to the 3.2% and 3.6% levels, respectively. However, the daily pace of increase has slowed. On March 3, the 3-year bond yield had jumped by double digits, but the increase narrowed to 2 basis points (1bp = 0.01 percentage point) the previous day. An increase in bond yields indicates a decline in bond prices.

In particular, the energy variable is identified as a core risk factor for the bond market. Kim emphasized, "Attention should be paid to whether the threat to the Strait of Hormuz will extend beyond simple price fluctuations to cause a structural supply chain shock. Specifically, whether Middle Eastern refining and petrochemical facilities suffer direct physical damage is the primary variable to watch." Furthermore, as Korea relies on the Middle East for over 60% of its crude oil imports, any supply disruption would inevitably have a significant impact. Kim noted, "In this scenario, the break-even inflation (BEI) reflected in the 10-year government bond yield, which currently has only risen by about 5bp, could rapidly climb to 15–20bp, exerting significant upward pressure on long-term yields."

Risks related to exchange rates and capital outflows are also a concern. Kim pointed out, "A strong dollar could lead to a pass-through into import prices and accelerate foreign capital flight." If concerns over foreign exchange losses trigger increased selling of government bond futures by foreign investors, volatility in the 3-year government bond yield would inevitably rise. The inflation trajectory is likewise considered a risk. Kim explained, "Rising energy prices will push up producer prices, which in turn will prompt upward revisions in the consumer price trajectory in the second half of the year. This could lead to a renewed increase in the inflation premium embedded in bond yields."

As a result, there are observations that the Bank of Korea's monetary policy stance could tilt more hawkish (favoring monetary tightening). Kim estimated, "If the risk of a rate hike is considered, the upward potential for government bond yields could expand by an additional 15–25bp." He added, "On the fiscal policy front, there is a possibility of extending expansionary fiscal policy and reigniting supply-demand pressures."

Kim concluded, "Currently, the lower bound for the 3-year government bond yield has been raised to around 3.0%—the base rate of 2.50% plus a risk premium. Until geopolitical risks peak and the exchange rate stabilizes, a cautious approach that leaves room for further increases in yields is necessary."

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