The Bank of Korea meets Friday and is expected to keep rates steady at 2%. However, we note that of the 14 analysts polled by Bloomberg, four are looking for the start of the tightening cycle with a 25 bp hike.

We do think tightening will begin in the third quarter, but it will be a very close call and could be either July or August. Minutes from the May 12 BOK meeting showed that three out of five board members wanted to send a strong signal to the markets that interest rates would rise soon.

Since May, the economic data has continued to come in strong, while price pressures are rising. CPI rose 2.6% year over year in June and is likely to move into the top of the 2% to 4% target range in the third quarter.

Korea policy-makers remain cautious, however, and so we look for only a 25 bp hike in the third quarter followed by another 25 bp in the fourth quarter. The South Korean won (KRW) has done well recently and recovered from second-quarter underperformance, and is one of the top performers in Asia so far in third quarter.

We have always thought fundamentals were strong, and so the combination of strong growth and higher interest rates should help KRW outperform further as risk appetite creeps back. Retracement levels to watch for from the June sell off are 1206 and 1197, break of which would target the June low in USD/KRW of 1169.

Malaysia Hikes Rates

Malaysia central bank hiked rates 25 bp to 2.75% as expected, and is the third hike in this tightening cycle. The Malaysian ringgit (MYR) too has done well, and is the second best EM currency so far in 2010.

Here too, fundamentals remain strong, and so the combination of strong growth and higher interest rates should also boost MYR. After the hike, the central bank was upbeat about the economy, saying the second quarter saw robust growth. It acknowledged external risks that might moderate growth, but added that strong consumption and investment, augmented by public spending, would keep domestic activity strong. We see rates continuing to rise by about 25 bp per quarter.

The ringgit should continue to outperform (best Asian performer year to date), and USD/MYR is on track to test the June low around 3.18 and the April 2010 low at 3.1720. After that is the April 2008 low at 3.13.

Indonesia and Inflation Risks

Indonesia is the other big Asian economy that needs to tighten, but policy makers there have been sanguine about inflation risks.

Finance Minister Martowardojo said he was confident inflation will stay within the 4% to 6% target range for this year, but we are not so sure. CPI rose 5.1% year over year in June and is accelerating, while core inflation of 4% year over year was the highest since January and rising.

The market is looking for a four-quarter hike, but we think it could come in third quarter if inflation continues to rise. The rupiah is another currency that's done well, and is the third best in EM YTD behind only COP and MYR as investors are drawn to the combination of strong growth and high interest rates.

The 9000 level has proven tough to crack, but if risk appetite continues to pick up, it's only a matter of time before it breaks. After that is the May 2007 low of 8650, but markets will be very nervous as IDR strengthens as the risk of capital controls rises if we break 9000.

So far, the moves have been mild (1-month holding period for T-bills) but this could be escalated if IDR strength becomes excessive. Despite the strong rebound being seen in Asia, there is still a bias towards a weak currency.
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