On the eve of the first rate cut by the US Federal Reserve since 2020 and since it began raising interest rates sharply two years ago, the gap between the interest rates on the US dollar and the shekel was 1% higher in favor of the dollar. The aggressive 0.5% cut by the Fed yesterday 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 fall to 3.5%, while in Israel the picture is completely different.
Israel’s interest rate has been stable at 4.5% since the beginning of 2024, and while the war and high uncertainty continue, it is difficult to see any change in the situation on the horizon. If that were not enough, there are even some market sources who believe that the Bank of Israel will have no choice but to take the extraordinary step of raising the interest rate in an extreme scenario. In addition, there is a renewed rise in inflation, which just this week reached an annual rate of 3.6%, above the upper limit of the 3% annual target range of the Bank of Israel. The high government deficit and the lack of clarity surrounding the 2025 state budget also contribute to the difficult situation Israel is in.
From the shekel to mortgages, the Tel Aviv Stock Exchange and foreign investors, what would happen if interest rates in Israel were 1% higher than those in the United States? The last time this happened was in 2013.
In general, and theoretically, in a normal situation, a narrowing of the interest rate gap between the US and Israel should have a positive effect on the Tel Aviv Stock Exchange. Lower interest rates in the US should weaken the dollar and strengthen the shekel, which should lower import costs and ease inflationary pressures. Another factor that could affect this is the movement of foreign investor funds into Israel. When the interest rate gap between Israel and the US is high, it is better to deal with a safer country that also offers higher interest rates, assuming other variables are constant. Thus, as the interest rate gap narrows, this should support the inflow of foreign capital into Israel.
But the current situation in Israel is different. The war is ongoing, uncertainty is high, and no one can predict what the situation will be in a year. “There is no doubt that the Fed’s rate cut and the narrowing of the interest rate gap are significant, but the impact on the domestic capital market in terms of the dollar-shekel exchange rate, inflation and bond yields will be minimal even if the interest rate gaps continue to narrow, due to the fact that the security situation is the main factor driving the dollar-shekel exchange rate,” says Modi Shafrir, chief financial market strategist at Bank Hapoalim.
Evidence of this emerged after the release of the CPI at the beginning of the week, Shafrir explains. When the shekel was expected to rise due to the sudden rise in the index and expectations that interest rates would not be cut, the shekel weakened. At the same time, government bond yields are also strongly influenced by both the risk premium in Israel and the inflation environment in Israel, which is accelerating, contrary to the global trend.
While higher interest rates are ostensibly supporting the shekel, those paying the price directly are many borrowers whose monthly payments are tied to the Bank of Israel’s interest rate, which has jumped by hundreds of shekels in the past two years. Those who expected the situation to change soon and to feel relieved are likely to be disappointed.
War is the focus
But what happens if Israel’s interest rates rise significantly over the next 12 months? On the face of it, the expected interest rate gap is in Israel’s favor, and should support the shekel’s appreciation and benefit inflation. But even here, Shafrir cautions, emphasizing that given Israel’s difficult inflation environment, it is more accurate to look at interest rate differentials in real terms. Even today, the two-year real interest rate in the United States is 2%, while the real interest rate in Israel is just under 1.5%, so the advantage that the high interest rate gives the shekel is diminishing.
In addition, in a review published last week by Bank Hapoalim, it was estimated that the interest rate gap in Israel’s favor “can persist as long as the war continues, but in our assessment, in a scenario where the war ends, it will lead to a rise in the shekel exchange rate and a quick reaction from the Bank of Israel.” In other words, the high interest rates in Israel due to the war and uncertainty will end quickly.
Bond anomaly
Rinat Ashkenazi, chief economist at Phoenix Investment House, agrees with Schwerer, explaining that the foreign exchange market is generally influenced by a variety of factors, especially the gap between imports and exports. However, there is no doubt that recent security developments are a central factor in its direction.
At the same time, Ashkenazi points to the expected impact 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 rate cuts and the narrowing of the interest rate gap with Israel are expected to put pressure on long-term government bond yields. However, the uncertain conditions in the Israeli economy, which include, among other things, the complicated financial situation and high inflation, are likely to offset the positive impact on the domestic bond market.”
Ultimately, regardless of the security impact, narrowing the interest rate differential between Israel and the United States may be beneficial to the Israeli economy to some extent, but the rising tension in the north may negate this benefit.
This article was published in Globes, Israeli Business News – en.globes.co.il – on September 19, 2024.
© Copyright Globes Publisher Itonut (1983) Ltd., 2024.