Won Surge Cuts Inflation Bets Most in Year as Demand Sinks

Inflation expectations in South Korea are receding the most in a year as a resurgent won makes imports cheaper and mourning over a ferry disaster damps spending.

The Korea Development Institute, a state think tank, and Australia & New Zealand Banking Group Ltd. last month cut their annual inflation forecasts and central bank data showed consumer confidence dropped to an eight-month low in May. The breakeven rate, a measure of price increases bond traders expect over the life of inflation-linked notes, fell the most since April 2013.

The won’s 4 percent advance this quarter is the best among 31 major currencies tracked by Bloomberg. KDI and ANZ predict inflation in 2014 will average less than the central bank’s 2.1 percent forecast even as the government plans measures to boost spending. Consumer prices rose 1.6 percent in May from a year ago, the most since July, based on the median estimate in a Bloomberg survey before data due tomorrow.

“The strong won continues to limit the upside of import prices,” Raymond Yeung, a senior economist at ANZ in Hong Kong, said in a May 29 e-mail interview. “Domestic consumption just extends its weakness in the aftermath of the ferry accident, renewing our concern of running disinflation.”

The Australian lender cut its inflation prediction to 1.9 percent from 2.6 percent. KDI on May 27 lowered its estimate to 1.6 percent from 2 percent, citing cheaper imports and weak demand after the ferry Sewol sank April 16, killing at least 288.

Inflation Outlook

The Bank of Korea expects inflation to average 1.5 percent in the first six months of this year and accelerate to 2.7 percent in the second half, it said in an April 10 statement. The central bank on the same day raised its full-year economic growth forecast to 4 percent from 3.8 percent.

The won advanced 1.3 percent last month and touched 1,017.25 on May 30, the strongest level since August 2008. It weakened for the first time in six days today, dropping 0.3 percent to 1,023.80 per dollar at 10:32 a.m. in Seoul.

The breakeven rate, which measures the difference in yields of inflation-linked government bonds and fixed-rate debt, dropped 24 basis points, or 0.24 percentage point, last month to 1.63 percent, data compiled by Bloomberg show. South Korean linkers handed investors a 0.2 percent loss in May, the first this year, Bank of America Merrill Lynch indexes show.

The yield for 1.125 percent linkers due June 2023 rose seven basis points in May and one basis point today to 1.8 percent, data compiled by Bloomberg show. The yield on benchmark government notes fell 19 basis points from April 30 to 3.34 percent, Korea Exchange prices show.

Korean Linkers

The current low inflation is reflected in the recent decline in prices of South Korean linkers, making levels favorable to start betting on the notes, Frances Cheung, head of Asian rates strategy at Credit Agricole CIB in Hong Kong, said in a May 28 e-mail interview.

“As the economic recovery goes on, inflation will go higher accordingly,” Cheung said. “We expect inflation to go to 3 percent by year-end.”

Trading volume for the 10-year linkers totaled 953 billion won ($934 million) in May, compared with 41.2 trillion won for benchmark government debt of similar maturity, according Koscom Corp., which compiles data from exchanges, investment associations and ratings assessors.

The low volume of trades in South Korean linkers prompted GAM U.K. Ltd., which manages $6 billion in emerging-market debt, to sell the securities in recent weeks, according to London-based investment director Paul McNamara.

‘Terribly Illiquid’

“The most important point about Korean linkers is that they’re terribly illiquid,” he said in a May 29 e-mail interview.

Issuance of the notes is also declining. The finance ministry sold 43.05 billion won of linkers at its monthly auction on May 19, the least this year, according to a statement on the government’s website.

Dongbu Securities Co., which said in December the linkers will be a good bet in 2014, is now more cautious.

“The direction of consumer prices would be upward, but there isn’t much momentum for short-term price gains,” Moon Hong Cheol, a Seoul-based analyst at the primary dealer, said in a May 30 telephone interview. “I don’t strongly recommend the securities at present, unless an investor has a really long-term focus.”

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