Once Governor of the Bank of Israel Stanley Fischer decided at the end of March to raise the interest rate by 50 basis points, the shekel's appreciation was inevitable. Fischer signaled to investors, foreign and local, that rising inflation was the main front, and that they should expect further rate hikes. Add to that the US dollar's weakness on world markets, and the result is a shekel-dollar rate at a low of NIS 3.424/$ this afternoon.
These conditions, the Bank of Israel's decision and the dollar's global position, severely limit the effectiveness of any intervention by the Bank of Israel in the foreign currency market to prevent the local currency from appreciating. It is doubtful whether the Bank of Israel will respond as it did a year ago, with massive foreign currency purchases. This time round, it will let the market mechanism work much more, even if now and then it appears as a buyer of dollars in order to stop irregular conditions developing on the market.
Those, more or less, are the factors behind the strengthening of the shekel today. The question is how long they will last. In fact, that is the key question for anyone making decisions on the basis of an exchange rate of NIS 3.424/$. For example, will the financial institutions employing analysts who forecast an exchange rate of NIS 3.25/$, or lower, be prepared to sign a contract to deliver a large quantity of dollars in 30 or 60 days, at a rate of NIS 3.30/$?
In reality, any projection or prophecy about the foreign exchange market is impossible, given the many unknowns at any moment. In the foreseeable future, the interest rate gap between Israel on the one hand and Europe and the US on the other will attract investors and pressure the exchange rate downwards. Even so, it is necessary to remember some of the lessons of the past few months when it comes to foreign exchange strategies based on interest rate gaps:
- Exposures to a currency with a high interest rate are built up gradually, but closed suddenly, or at least very quickly, when expectations change. As in any other financial sector, investors join in slowly, but when the need arises to take profits or to get out, there is a pretty good chance that everyone will be racing for the exit.
- The return on the interest rate gap between two currencies is only an expression of the risk of depreciation of the currency bearing the higher rate, and, in time, the risk materializes. This at least is what economic theory says. Market players don't really take much notice of this, as is well known, because they assume that they will always know how to get out in time. Sometimes they do time it right, but sometimes they have to take losses.
These two remarks are apposite in the context of one fundamental question: what could cause expectations to change to a depreciation of the shekel? Could it be Middle East politics, the diplomatic tsunami that the defense minister warns is coming, or security tension? Could a slowdown in inflation, leading the Bank of Israel to slow the pace of interest rate rises, change investors' minds?
At the moment, investors are not bothered by these questions, and are continuing to feed demand for shekels. Some of them are about to discover the less pleasant side of trading according to interest rate gaps.
Published by Globes [online], Israel business news - www.globes-online.com - on April 13, 2011
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