Market expectations for additional rate cuts are gradually fading. Government bond yields rose across the curve in the past few days after hitting the bottom on 10 Sep. In the interest rate swap market, the implied probability of a rate cut within the next 12 months has fallen to about 30% from the peak of 40% one week ago. The backdrop is that the Bank of Korea (BOK) held the benchmark rate steady at 1.50% last Friday in a unanimous vote. On the other hand, the US Fed will meet soon this week to discuss rate decisions. About one half of the market participants are looking for a rate hike from the Fed.



Monetary tightening by the Fed may not be a big constraint on the BOK's policy. The potential pressure of capital outflows triggered by Fed tightening should be limited and manageable, thanks to Korea's strong international liquidity position. The country's total external assets are adequate to cover total external debt (1.7x), foreign reserves are more than sufficient to cover short term foreign borrowings (3.1x), and the current account is in strong surpluses (8% of nominal GDP). Given that the KRW is slightly overvalued as a result of the sharp depreciation of the yen and euro, the BOK would like to tolerate some weakness in the KRW brought by possible US rate hikes and USD appreciation.



Growth and inflation data should remain the key determinants for domestic interest rate policy. "Given that domestic demand is recovering from the slump caused by MERS and the positive effects of earlier monetary easing have become visible in the property and credit markets, we think the BOK will refrain from further slashing rates from the current levels," commented DBS Group Research.

Barring a sharp deterioration in exports, the overall economic trend shouldn't deviate much from the BOK's base case scenario going forward.