After a sharp leg higher in longer-term yields during the first quarter, market participants recently shifted their focus toward the longer-term growth outlook for the global economy. This shift repriced longer-term yields lower, but for shorter-term yields, markets seemingly are pricing in aggressive future rate hikes for selected economies.
While not unachievable, the bar is high for those central banks to overdeliver, which we believe offers carry opportunities for investors in the medium term.
One of those economies is South Korea. Over the course of 2020 and up until now, South Korea’s economy found support in China’s economic rebound from the lockdown, global demand for semiconductors and the tight coordination between the government’s fiscal programs and the Bank of Korea’s (BoK) monetary policy. When Governor Lee of the BoK noted in May that the central bank would prepare for an orderly exit from current accommodative monetary policy (calling it normalization but not tightening), markets were quick to price an aggressive hiking path with most rate increases expected to materialize within the next two years.
However, the recovery in South Korea has been uneven across households. One of the impacts of the recent policy mix has been spiraling real estate prices. Small and medium-sized enterprises (SMEs) are struggling amid a new COVID-19 wave, while there are no signs of inflationary pressure. Indeed, financial imbalances due to surging real estate prices and struggling SME’s is a key concern for the BoK. They are however not alone. Similar patterns can be observed across several other economies, including New Zealand, Canada and the Czech Republic, leaving individual inflation dynamics aside. All are pricing in aggressive hiking paths, while local regulators are beginning—or planning—to tighten macroprudential policies to cool down local real estate markets and keep financial imbalances in check.
With front-end curves this steeply priced and elevated global PMI numbers set to cool, we see opportunities to receive carry in the front end. However, there is little doubt that some of the rate hikes priced in currently will come through over time. This could shift potential profits from receiving front-end rates toward the medium term of the trade duration. In South Korea, receiving two-year swap rates currently pays 23 bps in carry and offers 22.5 bps in roll-down over one year. In the Czech Republic, two-year interest rate swaps pay investors 31 bps in carry and 30 bps in roll-down over the same period. We view these levels and the defensive nature of this positioning against growth setbacks as attractive.