Discount Bank: Don't bet against the shekel


Trading Room market strategist Shmuel Katzavian analyses why the Israeli currency will likely continue to strengthen in 2020.

Since the end of 2018, the shekel has been strengthening, and ended 2019 with an 8.3% gain against the basket of currencies - a record for a single year. A stronger shekel was Israel Discount Bank's basic forecast a year ago.

Among the main currencies, the sharpest strengthening of the shekel since late 2018 was against the US dollar. The shekel has also continued appreciating against the world's other currencies since the beginning of 2020. The strengthening of the shekel also stands out when examining the trend over the past 10 years, in which the Swiss franc was the only other currency besides the shekel to gain ground against the dollar.

The generally recognized explanation for the strong shekel in recent years rests on many structural factors, among them Israel's tech exports, sound economic fundamentals, low debt-to-GDP ratio and stronger growth than in other Western countries. At the same time, this is not news. These factors alone cannot explain the consistent long-term and steep strengthening of the shekel over the past year.

Other factors also affected the strength of the shekel, some of which are less well known. First of all, we will list several of the financial factors that are accelerating shekel gains: relatively low pricing of the shekel following its weakness in 2018, a change in direction in capital market sentiment in 2019, and the expansionary policy by the central banks of the US and Europe, combined with the lack of change in Israel's interest rate.

Cheap pricing of the shekel

The shekel's weakness in 2018 made it relatively cheap according to a purchasing power parity (PPP) model. The PPP method estimates the "fair" exchange rate between two currencies according to a rate that balances between the commodities baskets of two different countries. For example, if the price of a given product goes up by $10 in the US and by NIS 35 in Israel, the exchange rate that balances trade between the two countries is NIS 3.50/$. Given a change in the relative prices, the exchange rate should change accordingly.

The PPP model is used by quite a few investment houses and trading systems around the world, but its ability to predict the direction of the exchange rate by itself, especially of the shekel, is not high. There are a fair number of factors, such as customs duties and tax rates, that cause a gap (sometimes a large one) between the results of the model and the prices of products. Nevertheless, the model provides a tool for the longer term that makes it possible to compare the underpricing or overpricing of a given currency in a historical comparison between the years.

For various structural reasons, the shekel has been priced more expensively in recent years (meaning that the shekel-dollar rate is lower than its PPP value). This is very logical, because of the special structural background conditions supporting the shekel, and for other reasons. In late 2018, however, the shekel-dollar rate was exactly according to the fair value, meaning that the structural pricing that existed in favor of the shekel over the years simply vanished.

This is a relatively rare situation for the Israeli currency. Experience in recent years shows that in cases in which such a situation occurs, in which the shekel is traded at close to its fair value (or 1% below it), the shekel strengthened against the dollar in the ensuing year. In other words, the strengthening of the shekel since early 2019 was greatly affected by its relatively cheap level in late 2018.

The shekel has already reverted to its "structurally expensive" level, although its pricing is not yet as extreme as it was during some of 2017, for example.

Change of direction in capital market sentiment

In 2018, the world's various risk assets fell sharply. This trend probably also affected the shekel, regarded by quite a few investors around the world as an investment asset for all intents and purposes. Some foreign currency investors simply joined the global trend and sold the shekel.

The trend reversed sharply in 2019, given the surprising change in direction by the US Federal Reserve Bank, which cut the US interest rate three times. The various assets in the capital market rose sharply, and this trend extended to the shekel.

There is a clear connection between the trend in the stock markets and the shekel. In quarters in which the global MSCI index goes up by over 2.5%, the shekel usually gained against the dollar - the shekel strengthened against the dollar in 15 of the past 18 quarters. On the other hand, in the other 18 quarters, in which a rise of less than 2.5% occurred (or the index fell), the shekel strengthened in only six of the quarters, and lost ground in the other 12. A strong connection can also be seen between the trend on Nasdaq and the shekel-dollar exchange rate trend, especially in recent years.

In summary, periods in which global share prices rose especially steeply saw substantial shekel appreciation, and this was the case in 2019, which was an especially strong yar for the global stock market.

Bank of Israel did not intervene in the market until November

Israel's relatively positive economic situation and the upward trend in inflation up to (and including) the May CPI (published in mid-June) led the Bank of Israel to leave the interest rate unchanged, and to refrain from intervening in the local foreign currency market. On the other hand, the US Federal Reserve cut its interest rate, and the European Central Bank (ECB) also gave expansionary messages, and also cut the interest rate on deposits.

In late November 2019, while simultaneously leaving the interest rate unchanged, the Bank of Israel began intervening in the foreign current market, and managed to moderate the shekel appreciation to some extent at the time. It appears recently, however, that the shekel has resumed its appreciation trend. The effect of the different in interest rates on the currency is therefore evident.

Looking ahead, it is important to note that the Bank of Israel is trying mainly to prevent exceptional shekel appreciation, especially when it believes that appreciation is "a result of causes of a financial character," as the Bank of Israel recently put it. Nevertheless, the Bank of Israel's actions are not designed to stop or reverse the shekel's appreciation in the long term when it is due to structural and economic factors, and there were also structural factors.

An important economic factor: a larger current accounts surplus

The current account reached a (cumulative) $13.7 billion surplus in the four quarters ending at the end of September 2019. This larger than the $9.4 billion cumulative surplus in the corresponding four quarters ending at the end of September 2018.

This is a factor that definitely affected the foreign currency market. The current account rose because of the net balance of Israel's exports of services, which grew from an $18.4 billion surplus in the four quarters ending at the end of September 2018 to a $23.8 billion surplus in the four quarters ending at the end of September 2019, as a result of the effect of an increase in technology service exports.

There was also some decrease in the goods deficit, but the dominant effect came from services.

A rise in the volume of exits and financing rounds

According to the IVC research company, the volume of exits by Israeli companies signed in 2019 rose to $21.7 billion, making it a peak year, except for 2017, which was very affected by the sale of Mobileye.

In addition, there was an annual increase of almost $2 billion in the amount raised in financing rounds by Israeli technology companies, in comparison with 2018.

It is important to mention that the volume and timing of the effect of the exits and financing rounds on the foreign currency market is less clear. Not all of the proceeds are converted into shekels, and the timing of such conversion is also unknown. In many cases, a long time passes before the deal is signed and the proceeds are actually received.

In any case, the upward tend in exits and financing rounds in 2019, in comparison with 2018, was a general background factor that supported a stronger shekel.

The effect of natural gas on the foreign currency market

The flow of gas from the Leviathan reservoir began at the very end of 2019, and is believed to amount to $2 billion a year, projected to rise to $2-3 billion several years from now (estimates are likely to change in the future).

It is important to emphasize that not all of this amount will affect flows in the foreign currency market. First of all, US company Noble Energy holds 40% of the Leviathan reservoir (its foreign currency flow will not be converted into shekels). Furthermore, not all of the production from Leviathan will be translated into net savings in Israel's general import-export energy balance (there will be internal effects between Leviathan and Tamar, for example).

In the bottom line, the effect of the gas on the foreign currency market was known, and is not a game changer for the market, and certainly not in 2019.

Israel's entry into the global bond indices

In my opinion, the expectation that Israel will enter the World Government Bond Index (WGBI) in April 2020 did not substantially affect the foreign currency market in 2019, but it is very possible that the strengthening of the shekel in recent days is already being influenced by expectations of Israel's accession to the global bond indices. In particular, it is causing foreign currency market speculators to buy shekels now.

According to various estimates, Israel's entry into the global bond indices at the beginning of April will create a flow of investments amounting to $3-5 billion. According to the existing figures (up to November 2019), it is hard to find evidences so far of an increase in activity by foreigners on the foreign currency market or government bonds market.

As of the end of November 2019, the proportion of holdings by foreign investors in Israeli government bonds was 5.6%, lower than the 6.7% proportion at the end of 2018, and fairly close to the 5.4% monthly average in 2017-2018. Actually, it is difficulty to determine that "foreign speculative money" entered the government bond market in Israel by November and created demand for shekels.

The announcement of Israel's entry to the WGBI was officially made on September 26 2019. It is hard to see a rise in the volume of foreign activity on the foreign currency market since then and much of the shekel gains last year were before then.

It is more reasonable to assume that the rise in foreign purchases of Israeli government bonds will be about the beginning of April or several weeks before - and it is possible that the strengthening of the shekel in the past few days is also in anticipation of Israel's entry to the WGBI.

Institutional investors reduced exposure to foreign currency

Israeli institutional investors reduced their exposure to foreign currency in 2019 by $5.8 billion (including exposure through derivatives). This is in contrast to 2018 when they increased their exposure to foreign currency by $7.7 billion.

At first glance this seems like a substantial change, but the connection is not as strong as it seems. In 2015 and 2016, for example, the institutions increased their exposure by $1.6 billion and $3.7 billion respectively but the shekel strengthened against the basket of currencies and even strengthened moderately against the dollar.

Indeed, the net activities of the institutions was modest compared with the accumulated volume of foreign currency purchases by the business sector, which stood at almost $11 billion up to September 2019. It seems that the institutional investors mainly strengthened the trend of shekel gains and were not the cause of the trend.

Expected trends in the short-term and long-term

The Israeli economy's fundamentals continue to support the strengthening of the shekel and in particular the expected sharp growth in the export of high-tech services. Forecasts are that the rate of the increase in exports will continue to grow while the rate of increase in imports will slow.

In the shorter term, it is possible that both foreign investors or speculators are now supporting the continued strengthening of the shekel because of Israel's entry to the WGBI Index and because as of the end of 2019 there had not been substantial foreign activity on the foreign currency and government bonds markets due to this.

Looking one year ahead, I don't believe the shekel will strengthen in 2020 as much as it did in 2019 even if Israel's economic fundamentals are strong. The pricing of the shekel is no longer as cheap as it was at the beginning of 2019. Stock market sentiment in 2020 is expected to remain positive although not as strong as in 2019.

So the Israeli currency will continue to be strong, especially against the European currencies but not to the extent that we saw in 2019. In the event that the dollar will strengthen substantially worldwide, it could strengthen against the shekel but more moderately.

The author is market strategist in Israel Discount Bank's Trading Room. The survey is for general information and should not be seen as a recommendation or advice regarding currency investment.

Published by Globes, Israel business news - - on February 11, 2020

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