Rising energy prices are fueling inflation pressures, while a simultaneous drop in demand from life insurance companies is weighing on South Korea's government bond market.
The yield on 30-year government bonds has climbed to 4.67%, marking the highest level since the maturity was introduced in 2012. Meanwhile, the 2-year bond yield inched up to 3.64%. With ongoing geopolitical tensions in the Middle East keeping international oil prices elevated, South Korea, which relies heavily on imported energy, is facing a growing inflation risk.
Data from South Korea's statistics agency earlier this month showed that the consumer price index (CPI) rose 2.8% year-on-year in July, marking the first time in three months it dipped below 3%. In May and June, inflation had remained above 3%, driven by higher oil prices from the Middle East conflict, with the index hitting a 30-month high of 3.2% in June. Inflation fell back into the 2% range following the signing of a termination memorandum of understanding between the U.S. and Iran, a pullback in international oil prices, and the effect of government price stabilization measures. However, core CPI, which excludes food and energy, accelerated from 2.5% in June to 2.6%, its highest since December 2023, driven by rising prices for IT equipment, electric vehicles, and travel-related services. For South Korea, the foundation for a decline in overall inflation is fragile, as core inflation remains elevated and agricultural product prices are still rising. The risk of price increases persists. If the Middle East situation flares up again, oil prices could easily reignite South Korean inflation.
In a statement after its price assessment meeting earlier this month, the Bank of Korea said that consumer inflation in August could rise due to a base effect from mobile communication fee discounts last year. The central bank added it would continue to closely monitor inflation, given the uncertainties from the Middle East conflict and persistent underlying price pressures. In fact, a report released by the Bank of Korea in June had already warned that even if the Middle East conflict ends and international oil prices fall, prices could maintain relatively high growth for some time due to factors like a consumption recovery and wage increases. The report expected that the positive performance of information technology (IT) companies would further boost consumption momentum, and the economic recovery would gradually strengthen. It noted that the recent trend of wage increases in some IT sectors could spread to the entire industry, intensifying upward price pressure.
Outgoing Bank of Korea Senior Deputy Governor Ryoo Sang-dai echoed this warning on Tuesday. Ryoo pointed out that as the semiconductor boom expands, wage increases in the IT sector are translating into persistent upward price pressure. He said, "The worry is that wage increases in the IT sector are becoming a source of upward pressure on prices. The magnitude of the price increase may not be large, but its persistence will be very strong." This suggests that a situation where the consumer price index remains above the central bank's 2% target for an extended period will not be easily changed. Ryoo also added that as economic growth continues to transmit to core inflation, the likelihood of the Bank of Korea further raising its benchmark interest rate is "high" unless there is an extreme shock. Just last month, the Bank of Korea raised its benchmark interest rate by 25 basis points to 2.75%, marking its first shift to tightening in three and a half years, and indicated the door remained open. Bank of Korea Governor Rhee Chang-yong stated at the time that future meetings would be "on-the-spot discussions," without ruling out any options. Currently, most market participants are focusing on the central bank's next rate-setting meeting on August 27, with the possibility of a consecutive rate hike being widely priced in.
Ryoo added that the recent stabilization of the Korean won and the decline in the benchmark Kospi index "have given the monetary policy committee members some leeway, but I don't think this is a key factor." He emphasized that "whether core inflation will remain high, the economy can sustain its growth momentum, and financial stability issues are the key points."
Beyond the inflation risk, a weakening of a key demand source—life insurance companies—is another major reason for the pressure on Korean government bonds. Due to changes in regulatory rules that have reduced the urgency to extend asset duration, South Korean life insurers have cut back on their purchases of ultra-long-term government bonds. Jo Yong-gu, a fixed-income strategist at Shinyoung Securities, noted, "Demand has been weak this year. The real money buying from insurers, especially life insurers, has been relatively soft." He added that the bond market outlook will depend partly on the global interest rate environment and South Korea's domestic bond supply, stating, "If the government cuts the proportion of ultra-long-term bonds in next year's issuance plan to below 30%, then demand for this maturity could bounce back."
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