Oil price impact and "K-shaped economy" push up interest rate hike expectations! South Korea's 10-year government bond yield breaks 4% for the first time in three years.

The Middle East war-triggered oil price shock has driven up inflation, while the wave of artificial intelligence (AI) infrastructure construction supporting the storage chip prosperity cycle is driving economic growth. The market is reassessing the path of South Korea's monetary policy. With the heating up of expectations for a rate hike by the Bank of Korea, the yield on South Korea's 10-year government bonds rose 11 basis points to 4.06% on Tuesday, breaking the 4% threshold for the first time since the end of 2023. The Bank of Korea will hold a policy meeting on May 28. The market is particularly interested in what interest rate signal the central bank will release at that time. Several major banks are raising their expectations for a tightening of monetary policy by the Bank of Korea. For example, Goldman Sachs currently expects the Bank of Korea to hike interest rates twice in the third and fourth quarters of this year, with each hike being 25 basis points, compared to their previous forecast of no rate hike for the entire year. Hanwha Securities predicts that the Bank of Korea will hike rates once this year, which was the same as their previous forecast of no rate hike this year. Park Junwoo, a fixed-income strategist at Hanwha Securities, said, "South Korea is facing a situation where rising oil prices mechanically drive up inflation, while at the same time, the semiconductor supercycle is driving up expectations for economic growth." Mirae Asset Global Investments pointed out at the end of last month that the massive wealth created by South Korean chip manufacturers will drive expenditures and inflation, prompting the Bank of Korea to hike rates at least three times in the next year. Choi Jinyoung, Managing Director and Head of Fixed Income at the company, said that bonuses for semiconductor company employees, high chip prices, and a booming stock market could intensify price pressures, leading the Bank of Korea to raise policy rates from the current 2.5% to a high of 3.5% by the second half of 2027. Choi Jinyoung believes that the background of the newly appointed Governor of the Bank of Korea, Shin Hyun Song, could also influence the policy direction. Shin Hyun Song will chair his first monetary policy meeting on May 28. He has extensive experience in international finance and policy making, and has long been concerned about exchange rate fluctuations. Compared to his predecessor, he is more likely to consider the exchange rate of the Korean won as a factor in interest rate decisions. This shift overturns the previous market consensus that South Korea will maintain policy stability this year. Investors are becoming increasingly concerned that the prosperity driven by AI will result in stronger-than-expected economic growth in South Korea, as reflected in the first quarter data, while high energy prices will further raise inflation. South Korea relies heavily on imported oil, making it more vulnerable to oil price shocks. In contrast, Nomura Holdings expects the Bank of Korea to maintain rates unchanged until next year (predicting no rate hike this year), but the bank believes that the Bank of Korea will signal a more hawkish stance in its dot plot. Economists at Nomura Holdings, including Jeong Woo Park, wrote in a report that the overall acceleration in inflation gives the Bank of Korea more reason to signal hawkishness, as it relates to inflation expectations and household perceptions of inflation. It is worth noting that Shin Sung Hwan, a well-known "dovish" member of the Monetary Policy Committee of the Bank of Korea, is about to leave office, making the overall stance of the committee more hawkish ahead of the policy meeting on May 28. South Korean Finance Minister Koo Yun-cheol's speech on Monday also seemed to foreshadow the prospect of a rate hike by the Bank of Korea. Koo Yun-cheol said that supported by the surge in global semiconductor demand, he expects South Korea's economic growth rate to exceed 2% this year, with a special emphasis on "inflation and the real estate market as direct risk factors," pointing out that these are issues that the government needs to address as a priority. Intensifying Middle East tensions adding pressure to South Korea's inflation Since the end of February, the US and Israel's attacks on Iran, leading to Iran's closure of the Strait of Hormuz, a global chokepoint for energy transportation, have led to a sharp increase in international oil prices. This is undoubtedly a huge burden for South Korea, which is highly dependent on imported oil. South Korea is highly reliant on energy imports, with about 70% of its oil and about 20% of its liquefied natural gas coming from the Middle East, most of which are transported through the Hormuz Strait. The continued blockage of the Hormuz Strait is putting pressure on South Korea's energy supply, with gasoline and diesel prices soaring, and raw materials such as naphtha and urea facing tight supply, affecting the economy and people's livelihoods. The energy shock has forced the South Korean government to take increasingly tough measures, including setting a ceiling on fuel prices to protect the economy. The authorities also said they would develop emergency plans to curb energy demand and stabilize prices. Against this background, South Korea's CPI in April rose by 2.6% year-on-year, a significant jump from 2.2% in March, marking the largest year-on-year increase since July 2024; the price of oil products soared by13% year-on-year, reaching a new high since the Russia-Ukraine war. More importantly, the pathway for inflation expectations to become self-fulfilling is opening up the one-year ahead inflation expectation in April rose to 2.9%, up 0.2 percentage points from March, just a step away from the 3% caution threshold. The life price index in April rose by 2.9% year-on-year, meaning that the increase in daily prices most frequently perceived by residents has exceeded the overall CPI. For every 1% increase in this perceived inflation, it adds 0.66 percentage points to inflation expectations this is the "expectations spiral" path that the Bank of Korea is most wary of. Several major banks have already raised their inflation forecasts for South Korea. JPMorgan has raised its forecast for South Korea's inflation rate in 2026 from 1.7% to 2.7%, while DBS Bank and Bank of America Merrill Lynch have raised their inflation rate forecasts to 2.6% and 2.9%, respectively. The average forecast for South Korea's inflation rate among 38 institutions at the end of April has risen to 2.5%. According to international investment banks and relevant institutions, if tensions in the Middle East continue and international energy prices rise further, South Korea's inflation rate could surpass 3% between May and September. The Bank of Korea has made it clear that, influenced by oil prices, it expects CPI to accelerate from April. Ryoo Sang-dai, Senior Deputy Governor of the Bank of Korea, even unusually sent a hawkish signal, saying, "It is time to consider stopping rate cuts, possibly even raising rates." Ryoo Sang-dai pointed out that despite increased economic uncertainty due to the Middle East conflict, domestic price increases in South Korea have exceeded previous expectations, and the semiconductor cycle is significantly stronger than the market expects. He further stated that the Bank of Korea may "possibly" signal a rate hike at its interest rate decision meeting on May 28 for the remainder of the year or at some point thereafter. "The 'K-shaped economy'" boosts the probability of a rate hike In the first quarter of 2026, South Korea's real GDP grew by 1.7% quarter-on-quarter, not only rebounding from a -0.2% growth in the fourth quarter of last year but also hitting the highest growth rate in five and a half years since the third quarter of 2020, nearly twice the Bank of Korea's forecast of 0.9%. However, when dissecting this growth rate, the structure is extremely uneven. According to a Bank of Korea report, if the IT manufacturing industry, which is at the core of semiconductors, is excluded, the economic growth rate will be directly reduced by about 0.4 percentage points. This is a precise representation of South Korea's "K-shaped economy." Lee Chang-yeong, who has retired as Governor of the Bank of Korea, stated at a press conference after the interest rate meeting in February that the three main factors driving the current economy are the growth structure led by the IT industry, rapidly rising asset prices, and the far exceeding of expectations in AI technology advancement. Economists at Citi forecast that driven by the global AI capital expenditure cycle, South Korea's semiconductor exports are expected to increase by 56% for the full year 2026, a significant acceleration from 23% in 2025 and possibly directly boosting GDP growth by 1.3 percentage points. A forecast report released on May 3 by the Korea Export-Import Bank also pointed out that exports in the second quarter are expected to surge by 30% year-on-year to around $230 billion, but at the same time, there is a decoupling phenomenon between export items semiconductors are surging while non-IT commodities such as petrochemical products are slowing down. This economic structure differentiation is forcing the Bank of Korea to make difficult decisions. In the view of Citi, South Korea's "K-shaped economy" requires a rate hike, the core logic of which can be summarized as "rate hikes driven by international balance of payments" the suction effect of semiconductor exports leads to a huge trade surplus and currency appreciation pressure, while inflation on the other end provides support. In this logic, the "K-shaped economy" plays a unique role it makes a rate cut unfeasible and increases the acceptability of a rate hike. A team led by economist Andrew Tilton at Citi wrote in a report, "AI-related exports may double this year, accounting for nearly 30% of GDP. Meanwhile, due to regional oversupply and energy shocks, non-tech exports will remain sluggish." "The structure of the 'K-shaped economy' indicates that a targeted and prudent fiscal policy should be adopted. With the significant growth in exports driven by AI, the Korean won should appreciate." In addition to high inflation, another reality is that senior officials at the Bank of Korea have reached a consensus that the Korean won is undervalued. This is essentially a policy signal the central bank believes that the current exchange rate level has deviated from the fundamentals and that interest rates are the most direct tool to correct undervaluation. Maintaining a low interest differential continues to pressure the Korean won, while initiating a rate hike can recalibrate the exchange rate. Under these constraints, a rate hike has transitioned from an option to a direction. Lee Chang-yeong once stated clearly, "Interest rates are not the appropriate tool to address the K-shaped recovery issue. This issue should be addressed through fiscal policy and other institutional reforms." In other words, monetary policy has been relieved of the mission to "restore the balance of the K-shaped economy," focusing only on its core role stability of inflation and exchange rates. The main purpose of the rate hike is to defend the Korean won exchange rate and restrain inflation, which is crucial for macroeconomic stability. Economists at ING Group summed it up if GDP growth far exceeds potential levels and inflation expectations further rise, the Bank of Korea will focus on its inflation target and enter a rate hike channel in the second half of 2026. The latest market pricing on Monday clearly reflects expectations for a rate hike by the Bank of Korea. According to interest rate forecasting models, the implied interbank lending rate as of August 8 has risen to 2.834%, implying about 1.5 rate hikes from the current benchmark rate of 2.50%. The market interpretation is that the Bank of Korea is likely to start a rate hike in July. A bond manager at an asset management company said, "The May inflation data is expected to further soar, and the pressure on the central bank is urgent. Unless there is a major unexpected event, a rate hike in July is a high probability event."