After weakening in 2018, the shekel has strengthened against the basket of currencies by 5.6% so far this year, reaching an all-time peak. In the same period, the shekel has strengthened by 3.4% against the US dollar and by 6.2% against the euro - an exceptional appreciation in comparison with the trend in most of the major currencies.
In giving our projections for 2019, we estimated that after the weakening of the shekel in 2018, most of the forces in the foreign exchange market would support renewed strengthening of the shekel against the basket of currencies in the coming years, for several reasons:
1. The expected improvement in the current account surplus as a result of the start of production of natural gas from the Leviathan reservoir, which will raise exports and reduce coal imports, and the expected growth in exports by Intel after its new Israeli fabs are complered.
2. Our view that pension and provident funds would slightly reduce their exposure to foreign currency, after its rise in 2018 to 20% of the portfolio (excluding the old pension funds).
3. The declaration by incoming Governor of the Bank of Israel Amir Yaron that the Bank of Israel would aim to reduce its involvement in the foreign currency market, in contrast to the prevailing approach at the bank in recent years.
4. The expected narrowing of the interest rate gap between Israel and the US, reducing hedging costs for exporters and financial institutions that invest pension fund monies overseas.
5. Continuation of the rising trend in foreign direct investment in Israeli companies - in 2018, such foreign direct investment totaled $21.8 billion, which compares with $18.2 billion in 2017 and $12 billion in 2016.
Contrary forces
Most of the factors mentioned above still apply, and we therefore remain with our strategic approach that the pressures making for appreciation of the shekel will continue. At the same time, at a more tactical level, the question arises whether the sharp appreciation trend of recent months will be halted, or whether perhaps market expectation of an interest rate rise by the Bank of Israel later this year (against the trend of most of the developed markets) will lead to further sales of foreign currency by financial institutions and foreign hedge funds?
In that context, we would point out that the local bond market estimates that the Bank of Israel's interest rate will rise once in 2019, to 0.5%, while the US market is pricing in one interest rate cut in 2019 and 1.2 cuts in 2020. In Europe, the market is pricing in stability in deposit interest rates and a first interest rate rise (of 0.10%) only in November 2021 (still to a negative level, of -0.3%).
As far as the direction of interest rates in Israel is concerned, we would mention that despite the economy's good growth rate in the first quarter, an annualized 5.2%, and the low unemployment rate, the Bank of Israel will not in our view change its interest rate in the course of the next few months (at least). Among the factors supporting this view are the sharp appreciation of the shekel since the beginning of this year to its peak against the basket of currencies, a rise in global risk, the dovish trend that has recently been characteristic of the major central banks, the surprisingly low inflation reading in April and our expectation of continuing low year-on-year inflation in the coming months. An interest rate hike might be on the cards if the US and China manage to sign a trade agreement, if the market ceases to price in an interest rate cut in the US, inflation rises towards the middle of the target range, and the shekel stops strengthening.
Going back to the foreign exchange market, two main factors could lead to a halt in the appreciation trend in the coming months:
1. Escalation in the trade war between the US and China will be liable to lead to sharp falls on the markets, and hence to a weakening of the shekel against the dollar, among other things because of the dollar's position as a safe-haven currency.
2. In its last interest rate announcement, the Bank of Israel expressed concern at the effect of the strong shekel on the inflation trend, giving rise to growing speculation that the Bank of Israel is preparing the ground for renewed intervention in the local foreign exchange market, which in the past few days has caused the shekel to weaken against the dollar.
Back to 2017?
In a trend similar to that of the past six months, in early 2017 too the shekel strengthened sharply, among other things following the release of growth figures for the fourth quarter of 2016 (an initial estimate of 6.2% in annual terms) which, as in the first quarter of 2019, were positively affected by a sharp, technical rise in new car deliveries before taxation changes came into force. Among other factors that at that time supported appreciation of the shekel were the fact that the Bank of Israel's foreign currency reserves were nearing the upper limit of the target range, boosting estimates that the bank would moderate its involvement in the foreign exchange market and might even raise its interest rate, and sales of foreign exchange by financial institutions in Israel, giving a picture similar to that of today.
At that time, these reports led to very large purchases of shekels against the US dollar by foreign investors, later joined by foreign currency sales by Israeli institutions, and continued strengthening of the shekel. Will this history repeat itself?
The author is chief strategist at Mizrahi Tefahot Bank (TASE:MZTF). Nothing in this article represents an alternative to investment advice that takes into account the individual circumstances and needs of each person
Published by Globes, Israel business news - en.globes.co.il - on May 23, 2019
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