Korean rate swaps dip on hopes of slower rate increases

HONG KONG: Short-dated South Korean interest rate swaps dipped and the curve steepened slightly on Tuesday as market players bet that any interest rate hikes in the near term would be very gradual.

Fixed income markets have begun to reassess the Bank of Korea's resolve to tighten policy aggressively after it surprised markets last week by holding interest rates, triggering a rally in rate markets.

Two-year Korean interest rate swaps edged two basis points lower to 3.63 percent, extending its fall by 8 bps since Friday while longer dated swaps have largely held their ground, pulling the curve wider.

"Given the flattening we have seen in the IRS market recently, this rally may have some more legs to run for now," said the head of research at a foreign bank in Seoul.

The drop in short-dated swaps has also spilled into the cross currency swap markets with one year swaps easing to 1.87 percent from 1.91 percent on Friday.

Bonds too have followed, though gains have been meagre, in comparison.

The yield on the benchmark five-year treasury bond was at 3.96 percent, a shade lower from Monday's close of 3.97 percent.

Seoul's reluctance to raise interest rates has also given some investors the opportunity to buy the Korean won, expecting the central bank to allow more currency appreciation to check inflationary pressures.

"We recommend going long the won versus the US dollar as we believe the Bank of Korea will plumb for more FX appreciation in the near term," Ashok Bhundia, Asia fixed income strategist, at Bank of America Merrill Lynch said at a media briefing on Monday.

For now though, the won has been on a weakening streak as investors have grown cautious about the near term economic outlook with outflows from the equity market also weighing.

Foreign investors have turned sellers in the equity market of late with net selling of 75.9 billion Korean won ($69.5 million) recorded on Monday and 825 billion won so far this year. They were net buyers in 2009 and 2010.

The weakness of the equity market, adding to the surprised Bank of Korea decision to keep rate on hold, could see another step down on Korean interest-rate swaps or weakening of the won, Societe Generale strategists said.