On the eve of the US Federal Reserve's first rate cut since 2020 and since it began raising rates sharply two years ago, the gap between the US dollar and shekel interest rate was 1% higher in favor of the dollar. Yesterday's aggressive 0.5% cut by the fed to 4.75%-5% closes the gap and the situation is set to change completely with forecasts predicting that by the end of the second quarter of 2025, the US interest rate will be down to 3.5%, while in Israel the picture is very different.
The interest rate in Israel has remained stable at 4.5% since the start of 2024 and while the war continues and the high uncertainty, it is difficult to see any change in the situation on the horizon. If that was not enough, there are even some market sources who believe that the Bank of Israel will have no choice but to take the unusual step and raise the interest rate in an extreme scenario. In addition there is a renewed uptick in inflation, which only this week reached an annual rate of 3.6%, above the 3% upper limit of the Bank of Israel's annual target range. The increase in the government deficit and the lack of clarity surrounding the 2025 state budget also contribute to Israel's difficult situation.
From the shekel, through to mortgage taking and the Tel Aviv Stock Exchange (TASE) and foreign investors, what will happen if the interest rate in Israel is 1% higher than in the US? The last time this happened was somewhere in 2013.
In general and in theory, in a normal situation, the narrowing of the interest rate gap between the US and Israel should have a positive effect on the TASE. A lower interest rate in the US should weaken the dollar and strengthen the shekel, which would cut import costs and moderate inflationary pressures. Another factor would be the movement of foreign investor funds to Israel. When the interest rate gap between Israel and the US is high, it is better to be exposed to a safer country that also gives a higher interest rate, assuming the other variables are constant. Therefore, as the interest rate gap narrows, this could support the entry of foreign capital into Israel.
But the current situation in Israel is different. The war is continuing, uncertainty is high and almost no one can say what the situation will be in a year. Bank Hapoalim chief financial markets strategist Modi Shafrir says, "There is no doubt that the cut in the Fed's interest rate and narrowing of the interest rate gap is significant, but the impact on the local capital market in terms of the dollar-shekel exchange rate, inflation and bond yields will be minor even if the interest rate gaps continue to narrow, and this is due to the fact that the security situation is the main factor moving the direction of the dollar-shekel exchange rate."
Shafrir explains that evidence of this came to light after the publication of the consumer price index (CPI) at the beginning of the week. When the shekel was supposed to strengthen due to the surprise jump in the index and estimates that the interest rate would not fall, the shekel weakened. At the same time, government bond yields are also heavily influenced by both Israel's risk premium and the inflation environment in Israel, which is accelerating, contrary to the global trend.
While a high interest rate ostensibly supports the shekel, those who pay the price directly are many of the mortgage takers whose monthly repayments are linked to the Bank of Israel interest rate, and have jumped in the last two years by hundreds of shekels. Those who expected that the situation would change soon and relief would be felt are likely to be disappointed.
The war is the focus
So what will happen if the interest rate in Israel is significantly higher in 12 months? On the face of it, the expected interest rate gap is in Israel's favor and should support the strengthening of the shekel and benefit inflation. But even here Shafrir has reservations and stresses that due to the challenging inflation environment in Israel, it is more correct to look at the interest rate differentials in real terms. As of today, the real interest rate in the US for two years is 2% and the real interest rate in Israel is a little less than 1.5%, so the advantage that the high interest rate gives to the shekel is disappearing.
In addition, in a review published last week by Bank Hapoalim, estimated that the interest rate gap in favor of Israel, "Can hold water as long as the war continues, but in our estimation, in the scenario of the war ending, it will cause an appreciation in the shekel exchange rate, and a swift response from the Bank of Israel." In other words, the high interest rate in Israel because of the war and the uncertainty, will quickly end.
The bond anomaly
Phoenix Investment House chief economist Rinat Ashkenazi agrees with Shafrir and explains that, in general, the foreign exchange market is usually affected by a variety of factors, and in particular by the gap between imports and exports. But there is no doubt that over the recent period, the security developments are a central factor in its direction.
At the same time, Ashkenazi refers to the expected effect of the narrowing of the interest rate gap between Israel and the US on the bond market: "On the face of it, the Fed's interest rate cut and the narrowing of the interest rate gap with Israel is expected to put downward pressure on long-term government bond yields. However, conditions of uncertainty in the Israeli economy, which include, among other things, the complex fiscal situation, and high inflation will likely offset the positive effect on the local bond market."
Ultimately, without the security impact, the narrowing of the interest rate differential between Israel and the US would be beneficial for the Israeli economy to some extent, but the heightened tension in the north could negate that benefit.
Published by Globes, Israel business news - en.globes.co.il - on September 19, 2024.
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