Fixed Income Weekly: The Fed will remain “behind the curve” on inflation

The author is an analyst at NH Investment & Securities. He can be reached at [email protected] — Ed.

Forward yields incorporate a real interest rate differential between the KTB and the US of 240 basis points. In the past, the spread has widened by more than 200 basis points when domestic inflation momentum has been stronger than in the United States. While acknowledging the need to continue the bullish rate cycle, we believe that the recent inflation scare in the KTB market is overdone.

The Fed will remain behind the inflation curve

Based on May’s FOMC minutes and April’s peak inflation growth (in mm), US TB markets are pricing in a year-end pause in the Fed’s tightening cycle. The Fed will likely take a break once the FF rate hits the 2.5% mark, but we believe it’s too early to factor in that expectation.

At the FOMC in May, Chairman Powell stressed the need to see a clear and evident easing of inflationary pressure. It should be noted that he said he was committed to focusing on controlling inflation, even if that turned out to be a mistake, indicating that he was aware of leading a “political failure” . In other words, the Fed is tightening even at the cost of a recession, which means it won’t preemptively reduce tightening pressure just based on a downward trend prediction of the inflation. We expect the Fed to stay behind the inflation curve.

The implication of the Fed’s strategy is that worries about policy failure will remain in play for now. The Fed should adopt significant new measures (50bp hike) and accelerate QT. US 10-year TB yields, which reflect medium/long term growth, are expected to trend lower through the end of the year.

Is the fear of inflation more important in Korea than in the United States?

We expect annual inflation growth in the United States to reach 7.1%. Currently, the euro-dollar futures market is pricing a year-end FF rate of 3%. Thus, the real US interest rate at the end of the year was -4.1%. On the home front, forward yields incorporate a benchmark rate of 2.83%. With inflation growth expected to stand at 4.5%, the real interest rate should stand at -11.7%. In other words, TB markets are pricing Korea’s real interest rate at 240 bps higher than that of the US.

After the 2008 global financial crisis and before the Covid-19 outbreak, the real interest rate differential between Korea and the United States averaged 140 basis points. The real interest differential widened by more than 200 basis points between 2011 and 2013, a period during which the growth rate of domestic inflation was higher than that of the United States. We recognize the need for the bullish base rate cycle to continue in Korea given the inflationary pressures. But, given the fact that current inflation growth in the United States is higher than in Korea, we consider the real interest rate differential of 240 basis points at the end of the year to be something little excessive. For now, the BOK will likely continue to raise base rates, even in anticipation of a recession; however, we believe that the tightening fears are reaching a fever pitch.

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