Israel's government bonds market is showing worrying signs. This week, the yield on ten-year bonds moved above the 5% mark for the first time since 2011. The meaning: demand for the Ministry of Finance's large debt offerings is declining, and the state is forced to pay higher interest. The 10-year bond is considered a "benchmark", a comparative measure of the state of the local economy in relation to the world.
Bank Leumi head of markets strategy Kobby Levi explains, "The government's fundraising needs have increased, the volume of Ministry of Finance bond issues has soared and the deficit has swelled, and Israel is issuing more bonds than usual." Levi points to data from the Bank of Israel, which show that foreign investors have sold government bonds in recent months. "As a result of excess supply, fund raising meets a more limited demand, and a gap has been created that has led to a gradual increase in market yields," he says.
Mizrahi Tefahot Bank chief economist Ronen Menachem attributes the rise in yields to the complex geopolitical situation with the war in Gaza now continuing for almost eight months, the IDF in the midst of a major operation in Rafah, international pressure on Israel growing, the ongoing conflict on the northern border and tens of thousands of evacuees who do not know when they can return home.
Menachem says, "It's not due to inflation and not due to differences in the effect of interest rates of the central banks, since there is no change in the estimates that both the US Federal Reserve and the Bank of Israel will not cut rates soon. This leaves the security and geopolitical deterioration as the main driver of the bond's behavior."
Israel's bonds are traded with a BBB minus rating, far below the official rating given by the rating agencies. In terms of the market, the risk of Israel's ten-year dollar bonds is priced slightly higher than countries like Peru, Mexico and Hungary.
The foreign currency market reflects a different reality
The foreign currency market reflects a completely different reality. The shekel-dollar exchange rate, which has been very volatile since the beginning of 2023 due to the judicial reform legislation and the war, has been surprisingly stable over the past two weeks, with the rate moving between NIS 3.66-3.70/$. Entry into Rafah, a request to issue warrants against the Prime Minister and the Minister of Defense, EU recognition of a Palestinian state - all of these are suddenly not so crucial for an index that is characterized by such high volatility."
The bottom line is that the two markets - the bond and foreign exchange markets - tell a very different story in relation to foreign investors. Levi explains, "The debt is mainly influenced by financial considerations, while the shekel exchange rate is also influenced by real considerations." He says Israel's economy and the high-tech sector in particular, show strong export activity. "As a result, exporters in Israel must convert foreign currency and buy shekels in order to finance the activity in Israel. This process creates pressures that support the appreciation of the shekel in the long term. On the other hand, in the short term, the negative sentiment creates pressures for the depreciation of the shekel, and these forces balance each other."
On the other hand, in the debt market, which is mainly affected by financial activity, there is a combined phenomenon - the volume and number of bond issues has increased, and the deficit has also climbed. These push an increase in yields.
Menachem explains for his part that the shekel-dollar exchange rate has been pricing the risk for a long period of time, it was simply ahead of the debt market: "To begin with, we are in an environment of excessive depreciation of the shekel against the dollar. The shekel would 'have' to be stronger under more routine circumstances. It is assumed that the depreciation stands at about 10%, and so the foreign exchange market does reflect the problematic environment, and was even earlier to do so compared with the bond markets."
Another difference between the markets, according to Menachem, is the high foreign exchange balances held by the Bank of Israel. "The policy of the Bank of Israel to sell foreign currency, if it comes to the conclusion that the shekel is depreciating at a rate that is not economically 'justified' is still valid." On the other hand, there is no such declarative policy of the Bank of Israel to purchase government bonds if the yields on them rise at a sharp and rapid rate. "This can also explain the difference in the behavior of the two channels," he concludes.
Responsible fiscal policy will help
The expectation that the Bank of Israel will not cut interest rates, unlike a few months ago, also has an effect. Levi explains that the drop in expectations contributed to the increase in yields in the short term, and the increases began to trickle down to the long term as well. Also, the foreign exchange market and government bond yields trade in a negative correlation in the long term, and Levi adds, "As the yield on bonds rises, the demand for financial investments in the shekel should increase."
Looking ahead, Menachem says, "If the Bank of Israel is able to announce the purchase of government bonds, this is an acceptable tool. If this happens, we may see a fairly significant correction in redemption yields, as happened to the shekel. In order to see an improvement in the debt market, we will also have to see an improvement in the geopolitical and fiscal picture."
Published by Globes, Israel business news - en.globes.co.il - on May 30, 2024.
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