[Lee Jong-woo's Economic Reading] Concerns Over Asset Bubble Amid US Interest Rate Hike... Bank of Korea Must Prepare for Rate Increase

Asset Allocation Concentrated in Long-Term Bonds
Real Estate Loans Linked to Short-Term Interest Rates
Long-Term Rates Insufficient to Prevent Bubble
Bank of Korea May Raise Rates Before Fed
Interest Rate Hike Debate Expected in Q2

Over the past 120 years, the long-term interest rates in the United States have experienced three directional reversals.

The first was in 1920. The yield on government bonds, which had risen to 5%, stayed near its peak for 13 years before declining. The second was in 1941. It took 10 years for the rate, which had bottomed out at 2.3%, to shift to an upward trend. The third was in 1980, but unlike the previous cases, the interest rate dropped rapidly after reaching its peak. At that time, the rise in rates was due to the U.S. Federal Reserve (Fed) raising the benchmark interest rate to 20%, so once the policy changed, rates quickly fell.

And now this is the fourth time. Last year, the yield on the 10-year U.S. Treasury bond fell to 0.4%, marking a bottom. Under normal economic conditions, it is difficult for U.S. interest rates to fall below last year's low, so it is appropriate to view this as the beginning of a process for a directional reversal. The key question going forward is whether rates will rise in a V-shaped pattern or enter a prolonged bottoming phase like in the 1920s or 1940s. The likelihood is for a bottoming phase. Even when the difference between past interest rate peaks and troughs was only 3 to 4 percentage points, it took several years for rates to change direction. This time, the difference exceeds 16 percentage points and the period spans nearly 40 years, so it will inevitably take a long time to shift to an upward trend. U.S. rates first fell below 3% in 2012. If we consider anything below that as a bottoming process, then the U.S. has already been in a bottoming phase for 10 years. If the upper limit of the bottoming range is 3%, U.S. rates are likely to rise further even without special measures like Fed rate hikes. After adapting to prices around 1.7%, rates will rise again, surpass 2%, and then challenge 2.5%. Although U.S. rates have risen over the past three months, there is still a considerable distance to the upper boundary of the trading range.

What impact will the rise in U.S. interest rates have on other countries' rates?

The rise in U.S. rates does not end with the U.S. It affects many countries in various ways, and South Korea and China are no exceptions. In the U.S., the average mortgage period is as long as 30 years, so the stock and real estate markets are heavily influenced by long-term interest rates. Thanks to this structure, the Fed was able to pursue low interest rate policies without worrying about asset bubbles. When a bubble seemed likely to form in real estate due to low rates, long-term rates in the bond market rose automatically to curb asset price increases. The year 2008, when housing prices rose without a corresponding rise in long-term rates leading to a bubble, was an exceptional case.

South Korea's structure differs from that of the U.S. Pension funds and insurance companies concentrate their asset allocation in long-term bonds, so they only consider when to buy long-term bonds, not reallocating assets by selling long-term bonds to buy stocks. Moreover, real estate loans are linked to short-term interest rates. Housing loan rates are determined by adding a small premium to bank bond rates, but since bank bond maturities are short, real estate loan rates also have short maturities. Therefore, even though a long-term bond market exists, long-term rates do not play a role in preventing asset market bubbles.

Because the function of long-term rates is weak, South Korea's central bank must tighten monetary policy directly when asset bubble concerns arise. This is why the Bank of Korea can raise rates before the Fed. This was the case right after the 2008 global financial crisis. Although the Fed began raising rates for the first time in December 2015, the Bank of Korea started rate hikes more than five years earlier, at the end of 2010. The hikes were not a one-time event but sustained, raising the benchmark rate from 2.0% to 3.25% over a year. This trend remained unchanged even when the Fed implemented quantitative easing in three rounds to supply liquidity.

This time as well, South Korea and China may raise rates before the Fed. Since the liquidity unleashed during the pandemic is likely to cause bubbles and long-term rates do not function to prevent bubbles as in the U.S., several analytical institutions have already suggested that the Bank of Korea should consider rate hikes as early as the second quarter. In the second half of the year, serious debates will arise over whether raising rates is appropriate. The period of rate cuts has ended, and we have entered a new phase, so it is necessary to prepare in advance for rate hikes.

Emerging markets have already begun raising rates due to the rise in U.S. rates. In mid-March, Brazil's central bank raised its benchmark rate from 2.0% to 2.75%, a 0.75 percentage point increase, and Russia's central bank raised its benchmark rate from 4.25% to 4.50%. Turkey increased its benchmark rate from 17.0% to 19.0%, a 2.0 percentage point hike. Other countries such as South Africa and India are also likely to raise rates soon. These hikes are due to inflation. Rising international oil prices and other commodity prices could transmit price pressures throughout the economy, so these countries are acting preemptively to prevent that. The effect of liquidity injections by advanced countries including the U.S. last year is expected to manifest this year, potentially causing significant inflation, which is troubling for emerging markets.

Capital outflows caused by rising U.S. rates must also be considered. While rising rates increase the competitiveness of U.S. bonds, the competitiveness of emerging market bonds declines. If there is no interest rate differential between emerging and advanced countries, there is no reason to invest in emerging market bonds while bearing economic and exchange rate risks. Since capital is likely to flow out of emerging markets, their central banks must raise rates to stabilize exchange rates.

Emerging markets have not yet fully shifted to tightening. Only a few countries with severe inflation and capital outflows have started raising rates. However, it must be acknowledged that the situation differs from last year when both advanced and emerging countries pursued accommodative policies. What affects financial markets is a relative, not absolute, concept. The fact that conditions have worsened compared to last year inevitably burdens financial markets. Interest rate changes do not end with rates alone. Given that rates have been kept excessively low for over a decade, the impact of rising U.S. market rates this time will be significant in many areas.