BOK could cut rate after bonds have a bad month

Korea’s inflation-protected bonds are set to have their worst month in a year, suggesting the central bank has room to surprise economists with one more interest-rate cut.

So-called linkers due June 2023 lost 1.9 percent this month. Notes maturing in 2021 indicate an inflation of 1.57 percent over their lifetime, less than the Bank of Korea’s (BOK) target of 2.5 percent to 3.5 percent through 2015. Governor Lee Ju-yeol lowered the benchmark rate to 2.25 percent from 2.5 percent on Aug. 14 and said price pressures are “not high.”

The first reduction in borrowing costs since May 2013 came after the BOK lowered its living cost estimates and Finance Minister Choi Kyung-hwan unveiled an 11.7 trillion won ($11.5 billion) spending plan to boost the slowest growth in more than a year. While most analysts predict Lee will keep interest rates unchanged, Samsung Asset Management and Eastspring Asset Management see room for a further cut.

“Another rate cut within the year is possible as one isn’t enough to support the government’s growth push,” Jack Kim, who helps manage 700 billion won of fixed-income assets for Eastspring, including Korean linkers, said. “Low inflation should make it feasible.”

Kim said weak domestic demand and a strong currency means consumer-price gains are likely to trail the central bank’s forecast. The BOK revised its 2014 estimate to 1.9 percent from 2.1 percent on July 10 and the finance ministry lowered its estimate to 1.8 percent from 2.3 percent on July 24. The won is Asia’s best performing currency in six months, gaining 5.4 percent to 1014.28 won per dollar through Wednesday, curbing import costs.

Samsung Asset Management, the nation’s biggest fund manager, sees scope for the BOK to lower its benchmark seven-day repurchase rate to 2 percent, most probably in October or November, said Lee Do-yoon, its chief investment officer for fixed income. Bank of America Merrill Lynch is the only forecaster among 26 predicting another cut in 2014, while the rest said they expect no change.

Korea’s break-even rate, a measure of price increases bond traders expect over the life of the 2021 linkers, fell from its 2014 high of 1.92 percent on March 4 to a seven-month low of 1.57 percent on Aug. 26. The finance ministry said in an Aug. 19 statement it sold 34 billion won of inflation-protected notes this month.

Consumer prices in Asia’s fourth-biggest economy rose 1.6 percent in July from a year earlier, the least in three months, official data shows. Economists predict that inflation will accelerate to 1.8 percent in the three months ending on Sept. 30 and then 2.3 percent and 2.5 percent in the following two quarters, respectively.

“Government efforts to boost domestic spending will bear fruit, pushing inflation to 2.7 percent by next quarter,” Park Sang-hun, chief economist at HI Investment & Securities, said. “Another rate cut is unlikely unless the global economy deteriorates significantly, which isn’t my baseline scenario.”

This month’s reduction was preceded by a shift in the BOK’s policy guidance after domestic consumption fell.

Governor Lee said after the BOK’s Aug. 14 policy review that while the threat of deflation isn’t big, it needs to be monitored.

“There seems to be a change in how the BOK views inflation,” Kong Dong-rak, a fixed-income analyst for Hanwha Investment & Securities, said. “They used to say inflation will face upward pressure, but now we’re seeing comments suggesting prices will stay low for a prolonged period.”

Kong said he sees the possibility of one more reduction this year, either in October or November.

Bloomberg