Support the economy or the shekel? BoI's dilemma

Prof. Amir Yaron credit: Steven Scheer, Reuters
Prof. Amir Yaron credit: Steven Scheer, Reuters

The Bank of Israel has hinted that it will not cut its interest rate tomorrow, but Bank Leumi, for example, sees room for a cut despite the risk to the currency.

Just two weeks ago, there were those who believed that in its forthcoming interest rate decision, due tomorrow (Monday), the Bank of Israel would raise its interest rate by a further 0.25%, from the current 4.75% to 5%. This estimate was based on the Consumer Price Index (CPI) reading for August, which was unexpectedly high, and indicated that inflation was not reducing in accordance with the Bank of Israel’s projections. A further interest rate hike was thought likely, as the Bank of Israel strove to bring the inflation rate back within its 1-3% target range.

The outbreak of war and the huge impact that the war is expected to have on the Israeli economy have led to a sharp reversal in analysts’ forecasts. Many on the market thought at the beginning of last week that the Bank of Israel should cut its interest rate in its next decision by 0.2%, or even as much as 0.75%, in order to boost the economy in the light of the negative effects of the war, with a sharp decline in demand and consumption already being felt.

"The understanding that the war in the south is going to be long, with broad implications, such as a sharp economic slowdown, led to the view that the interest rate needed to fall," says David Reznik, senior fixed income analyst at Bank Leumi, taking to "Globes".

Last Tuesday, however, Deputy Governor of the Bank of Israel Andrew Abir hinted at a meeting with economic forecasters that the central bank did not intend to cut its interest rate, at least not substantially.

A press release following the meeting stated: "The Bank of Israel’s policy is focused on stabilizing the markets and creating maximal certainty for the economy and the public at this time. The Bank has started using a dedicated tool to stabilize the foreign exchange market, which has contributed to stabilizing and calming other markets as well, and we aim that the other monetary policy tools will not pose a challenge to this aim in the immediate term. As governor Yaron said earlier this week in his speech for the G30 group: ‘The main inflationary risk in the past nine months, and now even more so, is depreciation of the shekel.’"

It should be mentioned that as soon as the war broke out, the Bank of Israel announced a program of selling foreign currency to the tune of $30 billion "to provide the required liquidity for continued orderly activity in the markets."

"The Bank of Israel stressed that it saw the depreciation of the shekel against the US dollar as the greatest danger as far as inflation was concerned, because of the rise in prices that it causes, and so it would appear that it does not plan a significant interest rate cut, but a token cut only, if any," Reznik explains.

Market intervention to moderate volatility

Cutting the interest rate is a measure that contradicts the Bank of Israel’s intervention in the foreign exchange market. While the bank is trying to prevent further sharp depreciation of the shekel, an interest rate cut would make investment in the local market (such as through Israeli government bonds) less attractive, and cause the currency to weaken further because of the transfer of money to markets offering better rates.

"The economy sustains a severe blow during wartime," Reznik says, "and we expect a strong fall in growth and a significant rise in the fiscal deficit. The market therefore thought at first that the Bank of Israel would want to boost the economy through an interest rate cut. The expectation of an interest rate cut despite the Bank of Israel’s intervention in the foreign exchange market to support the shekel stemmed from the view that opening up interest rate gaps that would create further pressure on the shekel was secondary to the need to support the economy."

Bank Leumi believes that the Bank of Israel can afford to lower the interest rate despite the additional risk of depreciation of the shekel, in order to lift the economy. There are those in the market who believe that the central bank will soon cut its rate, perhaps not at a scheduled decision date. Reznik stresses that "the degree of uncertainty arising from the war is very great, and the Bank of Israel will have to weigh up the risks at short intervals."

Government bond yields up sharply

Meanwhile, yields on ten-year Israel government bonds have risen to 4.4%, from around 4% a month ago. Reznik explains that the yields have risen to compensate for higher perceived risk. "Israel government bonds are a conservative instrument, but not risk free, and so they are affected when the country’s risk premium rises," says Reznik. "In addition, the country’s growing fiscal deficit and the fear that its sovereign credit rating may be downgraded in the near future should certainly lead to a rise in long-term bond yields. Short-term bond yields are actually falling, which reflects the flight to safer assets because of the geopolitical situation."

On the Tel Aviv Stock Exchange, the Tel-Gov Shekel 10+ Index, which covers government bond series with tenors of ten years or more, is currently at a peak, with an implied yield to redemption of 4.7%, up from 4.5% just before the outbreak of war, and from 4% at the end of July. The risk premium in credit default swaps (CDS) for Israel government bonds is at a ten-year high.

The simple reason is that investors are selling government bonds because of fears concerning the Israeli economy, including the possibility of the shekel weakening and making imported products more expensive, thus stoking inflation, and compelling the Bank of Israel to maintain a high interest rate. These factors are leading to a sell-off of government bonds and a rise in their yields.

Published by Globes, Israel business news - - on October 22, 2023.

© Copyright of Globes Publisher Itonut (1983) Ltd., 2023.

Prof. Amir Yaron credit: Steven Scheer, Reuters
Prof. Amir Yaron credit: Steven Scheer, Reuters
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