USD/KRW Forecast: Short-Term Won Weakness Ahead of Long-Term Appreciation
- Short-term won weakness likely as dollar benefits from rising real interest rate spreads.
- Sronger growth and lower inflation combined with slight currency undervaluation should see won appreciation long term.
Short-Term / Tactical Outlook: Won at Risk from Rising Real Yield Spreads
The US dollar looks cheap relative to the won in the near term following the significant rise in real interest rates in the US. The last time 2-year interest rate swaps adjusted for long-term breakeven inflation expectations were this far in the US’s favour, USDKRW traded roughly 20% higher. We see KRW1,200/USD as a reasonable short-term target.
*Numbers 1-5 reflect order of historical importance in driving the currency pair. **Negative sentiment towards the currency/economy is views as contrarian bullish. See here for a more detailed understanding of short-term currency drivers.
USDKRW remains locked in a relatively tight trading range with implied volatility measures showing no signs of a breakout. Sentiment and positioning figures do not show any particular bias in either direction. Both central banks harbor a neutral stance with hiking cycles likely to have come to an end. The BOK is unlikely to directly intervene in the currency other than to smooth out volatility.
The spread of US over Korean 2-year inflation-adjusted swaps is now firmly in positive territory and the steep 200bps rise it has seen over the past two years suggests that USDKRW should face upside pressure from the impact of divergent monetary policies in effect over the past two years.
We believe that a part of the won’s outperformance relative to real interest rate spreads can be put down to the external improvements seen in the Korean economy over recent years which have seen it move from a sizable external debtor to a modest creditor, with its large current account surplus protecting the won from Emerging Market portfolio outflows. The fact that Korea’s 5-year CDS has continued to decline, currently trading at around 40bps, helps explain the won’s outperformance.
However, we do not believe that the Korean won is immune from weakness simply because it has a strong external balance sheet, as the narrowing real interest rate differential with the US should eventually begin to dominate. The last time 2-year interest rate swaps adjusted for long-term breakeven inflation expectations were this far in the US’s favour, USDKRW traded roughly 20% higher.
The recent drop in oil prices is lending greater support to the Korean economy than the US given the former’s greater dependence on energy imports, but overall the balance of short-term forces is to the downside for the won and to the upside for USDKRW.
Long-Term / Structural Outlook: All Signs Point to Steady Won Appreciation
Over a multi-year period we should expect gradual Korean won strength owing largely to higher levels of real GDP growth and lower inflation. Slight fundamental undervaluation is an additional supporting factor while the likelihood of higher interest rates will add to total return gains.
*Assumes a 1 percentage point increase in productivity improves fair value of currency by ~0.5% based on the Balassa-Samuelson effect. See here for a more detailed understanding of the key long-term currency drivers.
Fewer Economic Distortions Support Korean Growth: We expect real GDP growth to be higher in Korea thanks to the relatively low level of economic distortions relative to the US. Korea scores highly in our productivity index, particularly relative to its level of GDP per capita, suggesting long term productivity growth of around 1.8% per year.
Korea’s Financial Sector sectors outperforms relative to the US thanks to low levels of public debt and its healthy external surplus, while the US is highly at risk from the fallout from its current equity bubble. Korea also scores highly in terms of Political Stability thanks to its entrenched democracy and limited social unrest. Meanwhile, the country’s highly-educated workforce sees Korea eclipse the US in terms of its Human Capital score.
We forecast long-term real GDP growth in Korea to outpace the US despite its significantly worse demographic outlook, which should have a positive impact on the won over the long term for three reasons. Firstly, stronger productivity growth should allow the currency to gradually appreciate in line with the Balassa-Samuelson effect. Secondly, faster real GDP growth should act as a disinflationary force, all else equal, allowing the currency to appreciate without undermining external competitiveness. Thirdly, faster real GDP growth should allow the Bank of Korea to keep real and nominal interest rates higher than the US, supporting total return performance.
*Contribution from savings rate gain/decline reflects the natural demographic effect of an increase/decrease in the proportion of the country’s population that is of net saving age.
Korea’s Low Public Debt Suggests Low Inflation: We forecast inflation to be roughly 0.8% lower in Korea relative to the US over the long term due largely to the much lower level of public and external debt. Relatively healthy public finances suggest that the need for debt monetization is much lower than in the US. The Bank of Korea should be easily able to raise interest rates should price pressures begin to rise, keeping a lid on inflation. Furthermore, while the US dollar has little risk of losing its status as the global reserve currency, its high level of external debt creates the potential for foreign central banks to draw down their reserves, effectively increasing dollar supply and increasing US inflation.
Valuations Slightly Favour the Won: Despite the won being overvalued in the short term relative to real bond yield spreads, longer term metrics such as the real effective exchange rate and the fair value implied by average price levels and GDP per capita suggest slight undervaluation. We estimate that this level of undervaluation should add an additional 1.0 percentage points onto annual Korean won appreciation over the coming years.
Higher Korean Rates to Support Total Returns: Despite lower inflation we expect nominal interest rates to be higher in Korea than the US over the long term. The BOK, unlike the Fed, does not have the need to keep interest rates low in order to prevent government debt costs spiraling. We forecast Korean nominal and real interest rates to average 0.5% and 1.5% higher than the US over the long term largely due to low rates in the US amid long-term financial repression. This should add to the won’s appreciation in total return terms.