"Bank of Israel should cut rate below zero"

Amir Kahanovich

Phoenix Excellence chief economist Amir Kahanovich believes interest rates will stay low for years to come and real estate prices could rise significantly.

As expected, the US Federal Reserve last week cut the US short-term interest rate by 0.25%, explaining that the decision was taken "in view of the implications of global developments for the economic outlook as well as muted inflation pressures." In a briefing for correspondents following publication of the decision, however, US Federal Reserve chairman Jerome Powell stated that the interest rate cut was part of an ongoing process of adjustment to the economic conditions, and did not necessarily reflect the beginning of a long-term cycle of cuts.

The dollar strengthened by 0.5% on the Bloomberg index in response, yields on US government bonds fell, and the S&P 500 stock index lost 1.1% of its value yesterday. At the same time, futures indicate a decrease in the probability of another interest rate cut in September from 74% to 54%.

Phoenix Excellence chief economist Amir Kahanovich said that Powell had surprised the journalists in the briefing by describing the interest rate cut as not really necessary, and as more of an adjustment to a mid-cycle stage. "It was interesting that the market did not agree with him. The yield curve slope has begun to fall in tandem with the stock market," Kahanovich explained. "Powell will have to take the hint or wait until the weakness is expressed more in real economic data," he added.

A few hours before, Governor of the Bank of Israel Prof. Amit Yaron also delivered a surprise by reversing his assessments of a month ago and declaring that the interest rate in Israel would not go on rising. "At the time of the most recent interest rate decision on July 8, the committee believed that according to the information we had then, conditions might emerge for raising the interest rate in one of the upcoming decisions. We nevertheless emphasized that given the substantial uncertainty about a number of important variables, it could not be ruled out that it would be necessary to conduct an expansive monetary policy for a more prolonged period," he explained.

"Since the interest rate decision, the inflationary environment has unexpectedly fallen off steeply with a 0.6% drop in the June Consumer Price Index," Yaron stated. "It is increasingly likely that the main central banks will resume expansionary measures, particularly important measures by the US Federal Reserve. This will have a strong effect on the exchange rates, which will in turn influence inflation. I believe there will be no interest rate hike for a prolonged period. Furthermore, additional tools are at our disposal, should they be needed."

"Up until now, in its protocols, the Bank of Israel referred only to actual policy, which has been stable until now, not the interest rate cuts around the world," Kahanovich declared. "It will now also have to cope with this new situation. In my opinion, the fact that the Bank of Israel made a monetary announcement other than at the usual time indicates that it is under a great deal of pressure."

This reversal by the Governor of the Bank of Israel only two weeks after he described a different economic environment and outside the planned announcement dates was probably due to the rapid strengthening of the shekel against the basket of foreign currencies. In Kahanovich's opinion, "If the shekel continues to strengthen in the near future, It is highly likely that the Bank of Israel will again reverse its policy on cutting the interest rate."

Kahanovich, who now holds a combined position in Excellence and its parent company, Phoenix, was formerly also chief economist of the Clal Finances investment house. In his weekly surveys in recent weeks, he has been stressing the need to cut the interest rate in Israel and predicting that this would indeed eventually occur.

For example, Kahanovich wrote three weeks ago, "The shekel continued to surge last week, supporting our prediction of an interest rate cut." He later stated, "In our opinion, as long as the Bank of Israel insists on not lowering the interest rate, it is likely that the slope of the curve (the yield curve for government bonds, O.C.) in Israel will continue falling, which indicates that the economy is grinding to a halt."

A week earlier, he wrote, "I only hope that the Bank of Israel does not make the mistake of resuming its foreign currency purchases. That would probably strengthen the shekel even more." This was one of the striking assessments featured in his reviews.

The various concepts presented by Kahanovich, combined with his boldness in presenting contrary and non-conventional views, brought us to interview him before yesterday's events. In the interview, Kahanovich explains why the interest rate in Israel and worldwide will remain low for many years and how this will affect property prices.

"The natural interest rate is negative, and nothing can change that"

"When I joined Phoenix in 2013, I presented an analysis to them in which I stated my opinion that we were in a world of very low inflation, in which yields and interest rates would not rise, and should even be negative. For the period of the analysis, it worked," Kahanovich explains. "There were years in which it didn't work for me, such as 2018, for example, when I felt a little unlucky, because I started working at Excellence then, and I came to create value for them. I recommended that they keep long-term bonds, and yields rose. I persisted in this, however, and I felt that in 2018, my role was to hold investment managers' hands and tell them not to give in.

"I told them to lengthen the bond periods, and not go overboard about global inflation, which heated up all of a sudden, because it wasn't sustainable. In contrast to other concerns that may try to change their attitude according to developments, such as temporary changes in oil prices or inflation, I say that there are very powerful forces sweeping over everything. So I try not to chase the market, but to look for what I really think is happening, and to say it, even if I have to experience a year in which my accuracy isn't good."

"Globes": Explain more thoroughly what your concept says.

Kahanovich: "It has several elements, the most important of which is the negative demography in many countries, such as Europe, for example when I see that while the banks published offers for deposits and long-term savings plans when we were children, they're now publishing offers of loans.

"The reason is that we're in a world in which there is no problem of savings; there's a problem of loans. People don't want money, and there are several reasons for this. One of the main reasons is demography. Young people characteristically have negative savings because of the loans they need to acquire education, housing, and so forth, but when they get older, their savings rate goes up and up.

"In a world in which the proportion of young people is getting smaller, compared with the older population, we see very strong demographic pressure to increase savings, and the European Central Bank (ECB) is also publishing this. Another strong force that the World Economic Forum is talking about is the end of the stage of large investments in the emerging markets, and the transition to a stage of savings.

"People there also want to save, after achieving some kind of status. According to the World Economic Forum, the global savings rate reached $60-70 trillion in 2015, and is projected to reach $400 trillion by 2040.

"These countries are becoming savers, and this means that something has to be done with all of this money. At the same time, countries have reached some kind of saturation in their debt raising. The US is still raising money, but in Europe, countries are already reaching their limits, and there is no intention of increasing government debt in Israel, either.

"Companies also no longer need as much money as in the past because of technological changes, which enable businesses to open stores online or sell software through the Internet. Most spending by a large proportion of the large high-technology companies is for salaries, because they don't need to build factories. Even Apple, which manufacturers products, distributes its money because it doesn't have anything to do with it."

What do you mean by saying that we have a problem of loans, not savings?

"We're reaching a world in which companies don't want money from us, and savings are only growing. What balances tis situation is interest. Interest is the price of money between the present and the future. As soon as more people to bring money from the present to the future (in other words, savings) than from the future to the present (in other words, a loan), the natural interest rate is negative, and you can't fight it.

"The Bank of Israel can keep the short-term interest rate high by force, but then the yield curve will be reversed. The reason is that the Bank of Israel doesn't determine all of the interest rates unless it tries to take control of the entire curve.

"So as of now, we're seeing the Bank of Israel's curve become flatter and flatter, until it eventually turns over. There are countries in which the curve has already turned over, because the central bank insisted on not lowering the interest rate."

What effect does a reversal of the curve have?

"Some say that when the curve turns over, it signals that a crisis is approaching, or that it creates the crisis. What is definite, however, is that when the curve turns over, it's not a good indication for the economy. The reason is that the central bank is in effect choking the economy with the high interest rate, and in Israel today, there is a high interest rate."

High is a question of definition. It rose once from a historic low of 0.1% to 0.25%.

"The interest rate in Israel has been falling for several decades. If you look back, we used to think every year that the interest rate was low. The natural interest keeps getting lower each year."

The distance from a 0.25% interest rate to zero is very small. Can you visualize the Bank of Israel lowering the interest rate below 0%?

"It has to lower the interest rate below zero. It can wait, but then it will start seeing side effects. It will see the shekel surge, very low inflation, and at some point, it will see companies here not finding investment opportunities at these interest rates. Companies won't want the money at these interest rates, and then the economy will grind to a halt.

"We have been seeing good data in recent years. Natural gas gave growth a push, the Leviathan field is due to begin producing gas soon, which will contribute more to this, and the Bank of Israel also predicts growth. But we're probably now at a peak of the interest rate, so in the next cycle, we'll have to go below zero."

"No bubble in housing prices in Israel"

Many people are saying that the low interest rate in the past decade inflated the prices of properties and created a bubble in both shares and real estate, and in the end, bubbles are deflated. Do you agree with this?

"What is a bubble? A bubble is a situation in which the economic value doesn't match the market value. Now let's see whether there is a bubble in housing prices in Israel. If we take an apartment and examine its value by capitalizing the rent paid in this today by the existing interest rates, we'll get more or less the apartment's market value. We know that rent isn't a bubble, because it's determined by supply and demand.

"In general, all of the properties that we capitalize today appear to be at equilibrium, and are properly priced. There are no indications today of a bubble like there were in the dot.com era in 2000 or the US real estate market in 2006-2007. What people are saying is that there's a bubble of everything because of the low interest rate, but the question is whether or not the low interest rate is distorted. So I claim that not only is it not distorted, but that it should be even lower. So not only is this not a bubble, but the market should be much higher."

How does your idea that the interest rate should be much lower work out in your investment recommendations?

"In our internal recommendations, we tell the investment managers to be risk-on, in other words, to be in risk assets, although it seems ridiculous, because the global economy is slowing, all of the main concerns are lowering their growth forecasts, and even the forecasts of companies themselves are going down. Despite all of this, the stock market continues to climb, because of the falling yields, declining financing costs, and declining capitalization rates, which mean that the value has to rise.

"The market today wants to continue to be in a sweet spot, in which the global economy is weak, but not collapsing, with a low interest rate environment. This is the best possible situation for the markets.

"Real estate prices also resumed their climb this year, for the same reasons. So we get back to and hear the question, 'How much can housing prices go up when salaries are limited?' But as soon as interest rates fall, the value of properties has to go up, and real estate prices can be double what they are now. If the private sector doesn't have enough money to buy a home because of this, then the proportion of home ownership will fall, and the ones buying apartments will be the pension funds."

Pension funds will buy apartments?

"They will buy the apartments and rent them out. The millennials and subsequent generations may not be able to raise the equity to buy an apartment, because a three-room apartment in Tel Aviv will cost NIS 10 million. So they'll continue paying the same rent, but it will be worthwhile for the pension fund to buy the apartment, even at that price, if the alternative is a negative return on government bonds. Real estate values may very well rise, regardless of salaries."

But then we see the recent report of the Bank of Israel Research Division, published in June (before the Governor of the Bank of Israel's remarks yesterday), and he talked about raising the interest rate.

"A distinction should be made between the Research Division and the Monetary Committee. I'm inclined to believe that the Research Division has certain ideas, and they want to generate self-fulfilling expectations. So they always predict 2% inflation, which they haven't reached for years. Over the years, their forecasts have always missed the target by a lot."

You said that "even a slight interest rate cut will probably not be enough to stop the shekel from strengthening," and you also emphasized that if the Bank of Israel resumes buying foreign currency, it will further strengthen the shekel. What is the explanation of that?

"An announcement about a purchase of foreign currency could strengthen the shekel, because it is liable to signal that there is no plan to raise the interest rate, and that will give traders confidence. Furthermore, such a measure will increase Israel's foreign currency reserves, and investors worldwide regard these reserves as having value."

Since the beginning of the year, we have seen a very strong trend of falling yields on long-term government bonds in Israel. Can this trend continue, or is it merely a return to the levels that prevailed before the rise in yields in 2018?

"It will definitely continue, for the reasons I described before, which are pushing down yields all over the world. The question is for what period it will continue. That's the problem in the market."

Published by Globes, Israel business news - en.globes.co.il - on August 4, 2019

Amir Kahanovich
Amir Kahanovich
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