Following statements from South Korean regulators that they are examining measures to curb risks associated with single-stock leveraged exchange-traded funds (ETFs) tracking Samsung Electronics Co Ltd (KRX: 005930) and SK Hynix Inc (KRX: 000660), these leveraged ETFs likely sold approximately $6 billion worth of shares on Tuesday to maintain their target leverage ratios.

Data indicates that the selling volume from these ETFs accounted for roughly 14% of the total trading volume for Samsung and SK Hynix on that day.

Lee Bok-hyun, Governor of the Financial Supervisory Service, stated at a press conference on Monday that authorities are considering enhanced monitoring of trading patterns and researching other market stabilization measures to limit the potential impact of sharp volatility from these products.

These leveraged ETFs utilize derivatives and swap contracts to provide leveraged exposure to underlying securities, offering investors the potential for returns significantly higher than the underlying asset's gains.

While they can amplify investment returns, concerns are mounting over their potential to exacerbate stock market volatility.

Lee pointed out that the vast majority of investors in these products are middle-class and salaried individual investors, and significant market swings could have a major impact on household finances during periods of turbulence.

Given the rapid growth in size of these leveraged products and their increasingly prominent role in amplifying Korean market volatility, their rebalancing mechanisms are under intense scrutiny.

Because these funds must rebalance daily to maintain a fixed leverage multiple, they are mechanically forced to buy when markets rise and sell when they fall.

Tuesday's market action in South Korea vividly illustrated this dynamic.

Shares of both SK Hynix Inc (KRX: 000660) and Samsung Electronics Co Ltd (KRX: 005930) fell over 12%, contributing to the KOSPI index's worst sell-off since the outbreak of conflict in the Middle East.

These two companies now collectively account for more than 55% of the KOSPI's weighting.

Rebecca Sin, a Bloomberg Intelligence ETF analyst, noted that Tuesday's selling pressure was not driven by investor redemptions but by the mechanical rebalancing required for these products to reset their daily double-leverage exposure.

She explained that this mechanism further amplifies market moves when the very stocks that constitute half the index are declining.

A report from Goldman Sachs' sales trading desk similarly suggested that hedging demand from leveraged ETFs likely contributed to the sharp declines in SK Hynix and Samsung shares on Tuesday.

The report highlighted that the daily mechanical rebalancing needs of these products create a pro-cyclical feedback loop, where a drop in an ETF's net asset value forces it to sell the underlying holdings, thereby reinforcing the downward trend.

Sin added that the broader $44 billion leveraged ETF segment tracking Korean stocks saw net outflows of approximately $1.7 million on Tuesday, though some products also experienced inflows.

She suggested these flows could stem from investors taking profits on SK Hynix and Samsung's strong year-to-date gains, while the sharp Tuesday drop provided a buying opportunity for others looking to enter at lower levels.

Investor interest in chips, AI, and the tech sector remains robust, with continued strong inflows observed.

Bank of Korea's Hawkish Pivot and July Rate Hike Probability

Notably, the increased financial imbalances stemming from leveraged investments have become one factor reinforcing the Bank of Korea's hawkish policy shift.

In its semi-annual Financial Stability Report released Wednesday, the central bank stated that despite rising domestic and external uncertainties, the country's financial system remains broadly stable, supported by strengthening economic growth, resilient financial institutions, and a robust external payments position.

However, the report also warned that financial imbalances could accumulate further, citing accelerating home price increases in Seoul and surrounding areas and investors' growing reliance on leverage to purchase assets.

The central bank further noted that while banks and other financial institutions maintain capital and liquidity buffers, credit risks for vulnerable borrowers and firms are rising.

Meanwhile, data from Statistics Korea showed the country's consumer price inflation accelerated to 3.1% year-on-year in May, the highest rate since the beginning of 2024.

Consequently, South Korea has comprehensively revised its inflation forecasts upward.

The Bank of Korea predicts consumer price growth will remain around 3% in the second half of the year, with core inflation expected to stay in the elevated range of 2%.

Furthermore, the central bank recently warned that even if the Middle East conflict ends and international oil prices fall, prices may remain elevated for some time due to factors like recovering consumption and rising wages.

The report anticipates that improving performance in the information technology (IT) sector will further boost consumption momentum, gradually strengthening the economic recovery.

However, recent wage increase trends in parts of the IT industry risk spreading to other industrial sectors, potentially adding further upward pressure on prices.

The Bank of Korea noted that while employee bonuses typically do not create significant demand pressure as they are not a permanent income increase, the current wave of "substantially increased, atypical bonuses" is expected to last at least into next year.

With inflation persistently high, the central bank's July or September monetary policy meetings are viewed by markets as potential windows for interest rate hikes.

Market analysis suggests that wage-driven inflation tends to be more persistent and difficult to subside quickly, potentially requiring sustained rate hikes by the Bank of Korea to dampen demand.

According to CME interest rate futures and forecasts from several investment banks, the probability of a Bank of Korea rate hike in July is as high as 80% to 90%.

Many market participants believe South Korea is entering a rate-hiking cycle.

Analysts generally expect the Bank of Korea to adopt a strategy of gradual tightening and preemptive inflation management, likely attempting small rate hikes rather than embarking on a sustained path of large, successive increases.

Analysis points out that the central bank's ability to hike rates is currently constrained by three main factors.

First, high household debt burdens make the sector highly sensitive to interest rates, and sustained hikes could suppress domestic demand.

Second, the economy's heavy reliance on exports and the semiconductor cycle means excessive tightening could amplify volatility from weakening external demand.

Third, the real estate and construction sectors remain relatively fragile, and overly rapid rate hikes could trigger financial stability risks.

Therefore, the Bank of Korea faces a difficult balancing act between managing inflation, supporting growth, and maintaining financial stability.