US Bond Market Reflects More Aggressive Tightening Than Fed Dot Plot... Service Prices Are the Variable

Although the US Fed has begun raising benchmark interest rates, the bond market is pricing in the possibility of more powerful tightening than the Fed's official outlook, the 'dot plot'. In particular, the structural rise in service prices has been identified as a major factor pushing up inflation expectations and pressuring long-term Treasury yields.

The 'Temperature Difference' Between the Fed Dot Plot and the Bond Market... Reflecting up to 4.75% in the First Half of Next Year

Woori Bank economist Choi Jin-ho analyzed recent movements in the US bond market through Morning Economy Plus on the 28th (local time). In the video, he explained that in the economic projection chart (dot plot) announced at the last September FOMC, the US inflation rate forecast was upwardly adjusted from the previous 3.6% to 3.7%, and the core PCE inflation forecast, which represents demand-side pressure, also rose from 3.3% to 3.4%. In particular, next year, core inflation, which excludes energy and food, is expected to be higher than headline inflation, suggesting the possibility that demand-side inflationary pressure may remain high.

The Fed's dot plot presents a main scenario of freezing interest rates next year after implementing one additional rate hike this year. However, the bond market's expectations are much more aggressive than this. Looking at the implied policy rate futures curve as of September 16, it appears that the market is already pricing in the possibility of the US benchmark interest rate rising to 4.5% or even the 4.75% level by the first half of next year. The video cited inflation as the background for the market's concern regarding the possibility of more aggressive tightening than the Fed's view.

Rising Inflation Expectations Caused by the 'Stickiness' of Service Prices

The core reason market participants are concerned about stronger tightening than the Fed's outlook is 'service prices'. The video mentioned that service prices have the largest contribution within core PCE inflation, which excludes energy and food, and analyzed that since service prices are generally inelastic to the economy, there is a low possibility that prices will drop dramatically fast even if monetary policy becomes aggressive. Since service prices are already showing levels above the policy target of 2%, the explanation is that the future path of US inflation could be turbulent.

This structural rise in service prices has resulted in higher inflation expectations (BEI). It was pointed out that the upper and lower bounds of the inflation expectation indicators have been structurally fixed (anchored) at a higher level since 2020. In particular, regarding the recent rise in US Treasury yields, the US 10-year yield is expressed as the sum of the Breakeven Inflation (BEI) and the Treasury Inflation-Protected Securities (TIPS) yield; the elevated BEI continues to push US Treasury yields upward, acting as a driver to keep long-term segment yields, such as the 10-year and 30-year, high. This trend could act as a negative factor for the stock market.

Joining the Global Tightening Cycle... Possibility of an Upward Shift in South Korea's Final Interest Rate

The US tightening move is spreading to the overall global monetary policy. In the case of Australia, three interest rate hikes were implemented in the first half of the year, and there is a very high possibility of an additional hike at the monetary policy meeting scheduled for this week. Japan and Europe also have a high possibility of additional hikes within the year. In the case of South Korea, it responded preemptively through consecutive interest rate hikes in July and August to secure room for response, but as the United States joins an aggressive tightening cycle, it is no longer free to maintain the logic of preemptive hikes.

In particular, the fact that South Korea's economic growth forecast is favorable is a variable. South Korea's economic growth rate is expected to exceed 3% this year, and next year's forecast is also expected to record a level of 2.9% as expected by the Bank of Korea. The video mentioned that considering the growth rate and inflation, the Bank of Korea's tightening stance could be maintained. Furthermore, considering the US tightening cycle and favorable growth trends, there is concern that South Korea's final interest rate level could be higher than the existing financial market expectation of 3.0%~3.5%. Accordingly, he advised that investment strategies should be devised considering that the direction of domestic and foreign bond yields is open to the upside.