South Korea's interest rate hike may land next week. Can the "bearish" KOSPI hold up?

Original Author: Xu Chao

Original Source: Wall Street News

The combination of hawkish signals from the Bank of Korea's governor and a technical bear market is pushing South Korea's capital markets to a tricky crossroads. The simultaneous escalation of three pressures—rate hike expectations, sustained foreign capital outflows, and structural risks from leveraged ETFs—is subjecting this once-booming market, fueled by the semiconductor boom, to a severe test.

Bank of Korea Governor Rhee Chang-yong stated clearly on the 9th that, considering the three factors of overshooting inflation, improved economic growth, and rising financial stability risks, "it is necessary to raise the base rate at an appropriate time." The market widely expects the Bank of Korea's Monetary Policy Board meeting on the 16th to announce a rate hike, which would be the first increase since August 2021. Following the announcement, the KOSPI index briefly surged over 4% in early trading before sharply reversing course, with the dramatic swing in market sentiment reflecting investor divergence and anxiety.

The current macroeconomic backdrop is not optimistic. The KOSPI has fallen over 20% from its June high, entering a technical bear market. On July 7th, the market triggered both a sidecar (program trading halt) and a circuit breaker in a single day, with Samsung Electronics and SK Hynix leading the sharp declines. Foreign investors net sold 148 trillion won in the KOSPI market during the first half of the year. In this context, investors are seeking answers as to whether the impending rate hike will serve as a boost from a policy signal or represent additional pressure on an already fragile market.

Rhee Chang-yong Consistently Sends Hawkish Signals, Rate Hike Path Becoming Clearer

Since taking office in May, Rhee Chang-yong has repeatedly emphasized the need for rate hikes publicly, with his language becoming increasingly explicit each time. In a speech commemorating the Bank of Korea's founding on the 12th of last month, he stated, "We should prioritize price stability and push forward with rate hikes as soon as possible." On the 17th, he spoke again, pledging to proactively implement policies to stabilize prices.

During a hearing at the National Assembly's Strategy and Finance Committee on the 9th, Rhee Chang-yong cited inflation as the core reason for rate hikes, specifically identifying the sources of price pressure. These include not only the oil price pass-through driven by the Middle East situation but also the wealth effect on households from massive performance bonuses paid by semiconductor companies like Samsung Electronics and SK Hynix, along with the significant rise in the KOSPI. He stated that both factors are jointly boosting consumption demand, and "the inflation rate is expected to remain high for a considerable period."

The Bank of Korea's business report submitted to the National Assembly also stated, "Considering changes in policy conditions such as overshooting inflation, improved growth momentum, and rising financial stability risks, it is necessary to raise the base rate at an appropriate time." This serves as the official institutional endorsement of the governor's stance.

Inflation Breaks 3% for Two Consecutive Months, Demand-Side Pressure Supplants Supply Side

On the data front, the urgency for a rate hike is clear. South Korea's June Consumer Price Index (CPI) rose 3.2% year-on-year, significantly exceeding the central bank's 2% target. The index for daily necessities, reflecting the cost of living, rose even higher by 3.4%. Inflation was around 2% in January and February, but following the escalation of the Middle East situation in May, it broke through 3% and has remained elevated since.

Rhee Chang-yong pointed out that inflation in the first half of the year was mainly driven by international oil price pass-through, a supply-side shock. However, he specifically emphasized that the driving force of inflation is undergoing a structural shift—the payment of large performance bonuses by major semiconductor companies like Samsung Electronics and SK Hynix, and the expansion of household assets driven by the sharp rise in the KOSPI, are both pushing up demand-side consumption pressure. This shift means that even if energy prices fall, the persistence of price pressures will be stronger.

The Bank of Korea expects that the downward pressure from international oil prices will be offset by expanding demand-side inflation, and "the CPI will continue to remain at a high level."

Citigroup Expects Two Rate Hikes This Year, Two More Next Year

Regarding the outcome of the 16th meeting, a consensus has largely formed in the market. Citigroup economist Jin-Wook Kim expects the Bank of Korea to raise the base rate by 25 basis points from 2.50% to 2.75% at next week's meeting, and signal a gradual pace of tightening.

Citigroup's baseline forecast is for one rate hike each in July and October of this year, followed by additional hikes in January and April of next year. Jin-Wook Kim stated that he expects Rhee Chang-yong to signal a 25 basis point rate hike every quarter in the second half of 2026, while maintaining a data-dependent stance for the first half of 2027 without providing specific forward guidance.

Citigroup also predicts the central bank may emphasize upside risks to its 2026 growth forecast, citing the upward revision of first-quarter GDP and the resilience of second-quarter economic activity.

This path implies that this rate hike is not an isolated event but the start of a multi-step tightening cycle. For a stock market already under pressure, the normalization of interest rates will constitute a sustained valuation headwind.

Stock Market Mired in Bear Market, Three Risks Escalating Simultaneously

Before the rate hike expectations materialized, the South Korean stock market had already undergone a sharp correction. The KOSPI fell over 20% from its June high, entering a technical bear market. On July 7th, it triggered both the sidecar and circuit breaker mechanisms in a single day, closing at 7246.79 points.

Foreign capital flight is the primary source of pressure. In the first half of the year, foreign investors net sold 148 trillion won in the KOSPI, with net selling exceeding 1.3 trillion won daily in the last two trading sessions, concentrated heavily on Samsung Electronics and SK Hynix. The logic behind the foreign exodus is clear: while the KOSPI had accumulated gains of around 60% from April to June, the Korean won depreciated sharply from 1200 to 1566 against the US dollar during the same period, hitting a 16-year low. This created significant currency conversion losses for dollar-denominated asset holders looking to cash out, making profit-taking a natural response.

Leveraged ETFs constitute the second risk. Fourteen single-stock 2x leveraged ETFs tracking Samsung Electronics and SK Hynix were listed at the end of May. On July 7th, they all plummeted 12% to 13%, with 13 out of the 14 products falling below their issue price of 20,000 won. The combined daily trading volume of the 16 single-stock leveraged and inverse ETFs reached 13.1 trillion won, accounting for over one-third of the total ETF trading volume across the entire market. Since Samsung Electronics and SK Hynix together represent over half of the KOSPI's market capitalization, the hedging sell orders triggered by the daily rebalancing of these leveraged ETFs add extra selling pressure on the underlying stocks, exacerbating the broader market decline.

Concentration risk is a structural concern specifically flagged by the Bank of Korea itself. In its written response to the National Assembly, the central bank warned that single-stock leveraged ETFs could lead to excessive capital concentration in a few stocks and increase market volatility through daily rebalancing.

Limited Policy Space, the "Semiconductor Paradox" Remains Unresolved

What perplexes the market is the deep divergence between fundamentals and stock prices. Samsung Electronics posted an operating profit of 89.4 trillion won in the second quarter, with semiconductor demand structurally strengthening due to the continued expansion of global AI infrastructure investment. However, these historically best-ever earnings are coinciding with the most severe sell-off on record.

The Bank of Korea has assessed this situation, acknowledging that the semiconductor market is showing a stronger upward trend compared to past cycles. However, it also pointed out that risks remain from uncertainties in AI profit prospects, potential pullbacks in actual investment by big tech companies, and energy bottlenecks.

The limitations of policy tools are also evident. A rate hike can help curb inflation and support the won, but for a market already in a technical bear market, rising interest rates will directly suppress valuations. The scale of the stock market stabilization fund established by the South Korean government is around 10 trillion won, a figure dwarfed by the 148 trillion won in net foreign selling during the first half of the year.

Deputy Prime Minister and Minister of Economy and Finance Koo Yoon-chul stated that the government is fully aware of concerns that leveraged ETFs are exacerbating market volatility, and relevant authorities are discussing ways to minimize volatility. However, no specific measures have been announced yet. An official from the Financial Supervisory Service also stated that regulators are evaluating alternatives such as tightening trading requirements for these products, but "any regulatory adjustment requires comprehensive consideration of its impact on the broader market."

A rate hike decision on the 16th is already a high probability event. The real variable lies in the answers to three questions once the tightening cycle begins: Can the Korean won stabilize? Can foreign capital outflows stop? And can leveraged products achieve a soft landing? The answers to these questions will largely determine whether the South Korean stock market can find its footing within the bear market.