The bond market’s warning

Kim Hyung-tae
The author, former president of the Korea Capital Market Institute, is a guest professor at Seoul National University.

Henriette Theodora Markovitch, better known as Dora Maar, was a French photographer and painter who was Pablo Picasso’s lover and muse. She recalled in her memoir how the artist could spot the slightest sign of physical abnormality with his first glance at a person. If a person that Picasso commented about visited the hospital, they would indeed learn from the doctor that there was something wrong. Picasso must have had unusually sensitive eyes to detect the subtlest signs of changes in people. The body emits various warning signs before illness deepens. We are only insensitive or choose not to notice.

The economy, too, sends out warning signals if it is weakening or sickening. Greater harm can be avoided if care is taken in advance. If the warnings are ignored, this can lead to a crisis.

The economy must pay special attention to signs from the bond market. The yield curve — a line that plots the interest rates of bonds from the shortest maturity to the longest — can tell a lot about the present economy and its future direction. A government bond stands at the crossroads of the fiscal and financial systems. Its movements also indicate inflation expectations. It is normal that a short-term bond would yield less than a long-term bond due to uncertainty about the future. If the yield curve flattens due to a narrowing spread between short-term and long-term bonds or becomes inverted from a negative spread — in other words, when longer-term bonds yield lower than short-term ones — economists instinctively see a recession in the making.

While exporters and businesses are wary of the ongoing trade war between the United States and China, markets are watching the flattening yield curve. What does the downward slope in the yield curve indicate for the Korean economy?

First, it could be a red flag about an economic downturn. In the U.S. and other advanced markets, an inverted curve in government bond yields forecasted a recession — usually a year later. Can the phenomenon be the same for Korea?

The treasury yield curve flattens for several reasons. Former Federal Reserve Chairman Ben Bernanke blamed excessive demand. As the Fed bought back more than $4 trillion worth in long-term treasuries for quantitative easing, it drove up government bond prices and pushed down their long-term interest rates. But the Korean central bank has never attempted quantitative easing or a massive-scale bond purchase. It cannot afford the unorthodox monetary easing because its currency is not a global reserve.

Another factor that can flatten the yield curve is hikes in the overnight benchmark rate. The U.S. central bank has pushed up its policy rate from 0.00 percent in late 2015 to 1.75 percent in June through seven hikes. Over the same period, the Bank of Korea raised its only once. The hike in the benchmark rate also cannot be cited for the case of Korea’s yield curve.

Foreign demand can also make the long-term yield lower. Demand for safe assets like U.S. bonds surges in the case of uncertain events such as a trade war. Since foreigners own around 50 percent of U.S. government bonds, their increased investment could push yields down across the curve. However, as foreign holding in Korean government bonds is around 15 percent, it cannot explain the fall in the yields of the longer-dated bills. Low expectations for inflation also help keep the yields low, a phenomenon shared in both the United States and Korea.

Another plausible factor is fear of an economic slump. Against a bleak outlook, investors purchase bonds beyond 10 years even at low return. They would settle for 3 percent. Since the Korean central bank won’t be able to raise the interest rate fast, the yield slope flattens out or even fall into the negative zone. There can be many theories behind the phenomenon with the U.S. yield curve. But it would be simpler to point to macroeconomic vulnerability in Korea’s case. The flat curve underscores a downturn in the economy and lack of momentum for growth.

Yet foreign investors keep their money in the Korean bond market. The long-term government bond yields are lower than much safer U.S. bonds of the same maturity. About a decade ago, foreign investors in Korean bonds were mostly for-profit private players. Now, public entities like central banks and sovereign funds have greater stakes in Korean bonds. The public funds invest in Korean government bonds as a part of mid-risk and mid-return portfolio. They are less sensitive to interest rate fluctuations and instead value stability in the economy — particularly the public finance. They also will pack out upon signs of instability in the Korean economy. Korea’s government bonds now appeal with their underlying fiscal integrity instead of interest rates. To prevent a pullout of investors in Korean debts, integrity in public finance has become imperative.

A flat yield curve is also a warning to the financial market. Life insurance companies have ramped up their investment in super-long government bonds regardless of their weak returns — ahead of the new global accounting standard effective from January 2021 that requires insurers to report their debts based on market value instead of book value. Higher demand pushes the yield on long-term notes down further. The yield rising on the shorter-end and falling in the longer-end bodes badly for banks that make money by borrowing at short-term loans to lend at a longer period.

An inverted yield curve has been followed by a recession in the United States without an exception since 1970. It is debatable whether the conviction will prove true this time as well. Shouldn’t the flattening curve worry Korea?

Translation by the Korea JoongAng Daily staff.

JoongAng Sunday, Aug. 18-19, Page 35