The term spread (gap) between the policy rate set by the Central Bank and the 10-year Government Bonds yield is an indicator that shows the market's perception and assessment of the economic outlook, credit risk, and economic policy. Because nominal rates tend to be lower the shorter the maturity, it is natural for the mid- to long-term yield on Government Bonds to be higher than the short-term policy rate; however, when the term spread widens excessively, it is interpreted as a result of an amplified risk premium caused by fiscal soundness uncertainty, policy uncertainty, and instability in the asset market. Conversely, when the spread turns "minus (-)" due to an inversion between long- and short-term rates, it is read as a harbinger of recession.
According to a 2021 study by the Bank for International Settlements (BIS), the risk premium on Government Bonds, revealed through rate spreads, is analyzed as a factor that amplifies exchange rate volatility. In particular, in Asian markets, instability in the Government Bonds market tended to spill over into exchange rate risk. In 2025, Korea's foreign exchange and Government Bonds markets can be seen as a case where this interest rate spread theory of exchange rate determination operated in the actual market. Changes in market perception of political instability and policy responses shook the term structure and amplified exchange rate volatility. The spread between Korea's 10-year Government Bonds and the policy rate carried different meanings by period and served as a key variable explaining the won-dollar exchange rate trend.
Policy credibility recovery drove rate and exchange-rate normalization
In Jan.–Feb. 2025, as the aftershocks of former President Yoon Suk-yeol's Dec. 3 martial law declaration continued, Government Bonds yields fell below the policy rate and the won-dollar exchange rate kept surging in the 1,400-won range. The spread between the policy rate and the 10-year Government Bonds yield was -25 to -15 bp (1 bp = 0.01 percentage point), marking a "negative rate spread" phase that reflected the possibility of a recession. As the view spread that the presidential impeachment situation triggered by the illegal martial law would constrain the government's ability to respond to the economy, market sentiment tilted toward betting on a downturn rather than a recovery. Even so, on expectations that the Bank of Korea (BOK) would hold rates at the Monetary Policy Board meeting in Jan. 2025 out of concern about the sharp rise in the exchange rate, the won-dollar exchange rate soared to 1,470 won on Jan. 13.
The negative rate spread and the surge in the won-dollar exchange rate, driven by recession fears, began to ease after the BOK cut the policy rate to 2.75% from 3.00% at the Monetary Policy Board meeting on Feb. 26. The government's formulation of a large supplementary budget also helped ease concerns about a policy response vacuum. The rate spread turned positive (+) after the BOK made an additional cut to 2.50% from 2.75% at the Monetary Policy Board meeting in May, and after the inauguration of the Lee Jae-myung administration through the presidential election on Jun. 4, it stayed around the appropriate level of about 30–40 bp. As the long-short rate gap normalized, the won-dollar exchange rate fell to 1,350 won at the end of June, the year's low. The gross domestic product (GDP) growth rate, which had fallen to -0.2% in the first quarter of 2025 (quarter over quarter), rebounded to 0.7% in the second quarter, lending support to rate and exchange-rate normalization. Analysts said easing political instability and a full-fledged economic recovery reduced the risk premium on Korea-linked asset. Kwon Hyo-sung, an economist at Bloomberg Economics, said, "The result is that expansionary monetary and fiscal policy led to tangible outcomes in the recovery."
Risk premium roiled rates and exchange rates
However, after Oct. 2025, rates and the exchange rate turned volatile again. The term spread, which had normalized amid expectations of recovery, widened, and the won-dollar exchange rate jumped into the 1,400-won range. Rising long-term rates are a sign of recovery, but during this period, instability in the real estate and other asset markets undermined the predictability of monetary policy and heightened financial market risk. Despite the Jun. 27 loan restrictions that banned mortgage loans on dwellings priced at 600 million won or more, the rise in Seoul apartment sale prices accelerated after September, prompting the government to take a hard-line step by expanding the land transaction permit system across all of Seoul and key areas of Gyeonggi Province. Even with the government's tough regulations, the upward trend in Seoul apartment prices did not abate, and the resulting decline in policy credibility led to a vicious cycle of adding a risk premium to long-term rates.
Even though BOK Governor Rhee Chang-yong emphasized an accommodative monetary policy stance, the focus of policy capacity on "reining in Seoul home prices" fueled the view that the BOK's rate cuts, which began in Oct. 2024, had effectively stopped at 2.50% per year. As a result, the 10-year Government Bonds yield surged to around 3.5%. With the new government's budget plan (around 728 trillion won), which doubled the budget growth rate (8.0%) of the previous administration, concerns that Government Bonds issuance would rise to 230 trillion won in 2026 and that national debt would surpass 1,400 trillion won had already created strong upward pressure on rates; then, as the possibility of a shift to monetary tightening was discussed, long-term rates moved in near-"spasm" fashion. The bond market's rate spasm worked to amplify won weakness.
In the foreign exchange market, concerns about capital outflows grew due to the outcome of the Korea-U.S. tariff negotiations, under which $200 billion would be committed in cash to a U.S.-focused investment fund over 10 years in partitioning, and the won-dollar exchange rate climbed back into the mid-1,400-won range after October. In this situation, the term spread, which was around 40 bp in early October, widened to around 90 bp by early December, and the won-dollar exchange rate also continued its high-altitude run into the 1,470-won range. During this period, the correlation coefficient between the term spread and the won-dollar exchange rate exceeded 0.9. The analysis is that rising long-term rates pulled up the won-dollar exchange rate. The diagnosis is that rate increases stemming from policy uncertainty and fiscal burdens expanded the risk premium on Korea-linked asset.
Market intervention effect is temporary… policy stance needs adjustment
As the surge in long-term rates and the won-dollar exchange rate emerged as a financial market risk, the authorities launched strong market interventions. On Dec. 9, the BOK conducted an outright purchase of 150 billion won in long-term Treasury bonds of five years or longer. An outright purchase of Treasury bonds to ease rising long-term rates was the first in three years and three months since the response to the Legoland crisis in September 2022 (a 3 trillion won program). On Dec. 24, the Ministry of Economy and Finance also announced tax incentives, including exempting capital gains taxes if overseas investors such as Korean retail investors trading U.S. stocks sell U.S. shares and make long-term investments in the domestic stock market, while carrying out market intervention to supply dollars to the foreign exchange market. The foreign exchange market estimates that, through the National Pension Service's hedging and other measures, more than 70 trillion won worth of dollars was supplied between Dec. 24 and 30, 2025. With these steps, the won-dollar exchange rate, which had surged to 1,483 won on Nov. 23, finished 2025 trading at 1,439 won on Dec. 30. Although the intervention pushed the exchange rate down by more than 40 won in a short period, the market mostly expects the rate to trend upward in the 1,400-won-per-dollar range in the new year. A senior financial industry official said, "Beyond adjusting dollar and Government Bonds supply-demand, policymakers should work to lower the risk premium on Korea-linked asset by revising policies with low market acceptance and predictability, such as excessive real estate regulations."