Report: 'Analysis of Korea-US Long-Term Interest Rate Synchronization'

Global inflation shock found to be the biggest driver

Policy expectations, not risk premium, transmit foreign shocks to domestic rates

Researchers urge active market communication to manage expectations

The US flag is illuminated on Sebitseom, a floating island complex in Seocho-gu, Seoul. [Yonhap]
The US flag is illuminated on Sebitseom, a floating island complex in Seocho-gu, Seoul. [Yonhap]

The root cause of the synchronization between Korean and US long-term interest rates — where a rise in American rates pulls Korean rates higher — is global inflation shocks, according to a new analysis. The key channel through which external shocks feed into domestic rates is not compensation for investment risk, but rather market expectations that the Bank of Korea will ultimately follow the Federal Reserve in adjusting its benchmark interest rate.

The researchers also recommended that the central bank engage in more active communication with markets to manage expectations that domestic policy rates will mechanically track those of the United States, as a way to ease the degree of synchronization.

Lee Hyeong-seok, an associate research fellow at the Bank of Korea's Economic Research Institute, and co-authors laid out these findings Sunday in a report titled "Analysis of Korea-US Long-Term Interest Rate Synchronization."

Analyzing daily interest rate data, the report found that the covariance of Korean and US long-term rates surged sharply in the immediate aftermath of the 2008 global financial crisis and again during the global inflation shock of 2021. A higher covariance means the two countries' long-term rates moved in the same direction with far greater intensity.

Volatility in both countries' long-term rates also spiked during those periods, meaning the two rates moved in effect as one whenever a major shock hit the global economy.

To identify the causes of synchronization, the report employed a Gaussian dynamic term structure model. The analysis found that global inflation shocks were the single largest contributor to Korea-US long-term rate synchronization.

Shocks originating from US long-term rates themselves also had a considerable effect, with the Federal Reserve's unconventional monetary policy measures — such as quantitative easing — being a prime example.

Particularly notable is the channel through which these external shocks are transmitted to Korean long-term rates. The analysis found that expectations about the future path of the central bank's policy rate had a greater impact than the term premium — the additional return offered to investors who take on duration risk.

In plain terms, when a global inflation shock or a shift in US monetary policy occurs, markets form the expectation that the Bank of Korea will adjust its benchmark interest rate in step with the Fed, and it is this expectation that drives domestic long-term rates.

The report estimated that, absent the global inflation shock since 2021, the yield on Korea's 10-year government bond would have been up to 1.5 percentage points lower than it in fact was — meaning the global price shock pushed domestic long-term rates up by that margin.

Conversely, without the Fed's unconventional monetary policy, the 10-year Korean government bond yield would have been up to 0.6 percentage points higher, suggesting that quantitative easing pulled down long-term rates not only in the United States but in Korea as well.

Even when the Fed was conducting unconventional monetary policy, the dominant channel of Korea-US rate synchronization remained policy expectations. Around the dates of major Fed quantitative easing announcements, both short- and long-term rates in Korea fell, and those moves were driven more by shifts in expectations about the future policy rate path than by changes in the term premium.

The report said that while Korea-US long-term rate synchronization is an unavoidable consequence of global economic shocks, its magnitude can be reduced through better communication with markets.

"Given that the most fundamental cause of Korea-US long-term rate synchronization is common external shocks, the phenomenon is an inevitable response to changes in global conditions," the researchers said. "However, expectations that domestic policy rates will also synchronize play a significant role in the process by which external shocks pass through to domestic long-term rates." They added that managing such expectations through communication with markets "suggests it is possible to ease the Korea-US long-term rate synchronization phenomenon to a certain degree."


kimstar@heraldcorp.com