Israeli Shekel Strength Driven by Institutional Investors, Not Interest Rates

Contrary to conventional market wisdom, the Israeli shekel has strengthened despite a series of interest rate cuts by the Bank of Israel, totaling 1.5%. Dr. Ilan Gidin explains that the primary driver is not the interest rate differential but the substantial capital flows from institutional investors. These investors, with significant exposure to overseas equities, need to sell dollars and re-hedge their positions whenever global markets rise, a flow that dwarfs the impact of minor interest rate changes.

Gidin further notes that when rate cuts are perceived as a sign of economic normalization and decreasing geopolitical risk, they can actually bolster the shekel. However, he cautions that if rate cuts are seen as a desperate measure due to economic weakness or political pressure on the central bank, the outcome could be different, though he does not currently consider this the main scenario.

The Bank of Israel's decision-making on further rate cuts is primarily influenced by core inflation, the labor market, wage pressures, deficit levels, defense spending, and the exchange rate. Only a resurgence in service inflation or a fiscal crisis could halt the downward trend in interest rates, according to Gidin.

Regarding the global rise in long-term bond yields, Gidin attributes it not to inflation but to increased government debt issuance in major economies like the US, UK, France, and Japan, the Bank of Japan's policy normalization, and the absence of central banks acting as default buyers. This environment leads to higher volatility for long-term bondholders without adequate compensation, prompting Gidin to favor shorter to medium-term maturities and express caution towards assets like long-term growth stocks and leveraged infrastructure.

On the subject of potential elections in Israel, Gidin dismisses the notion that they inherently create significant market volatility, citing the market's relative indifference to five elections in four years. He identifies the institutional conflict over the judicial system in 2023 as the true source of increased risk premium, which broke the historical correlation between the shekel and global stock indices and signaled a new structural risk to foreign investors.

Gidin identifies three key indicators to monitor: the Bank of Israel's independence and fiscal rules, budgetary commitments during election campaigns and their impact on the deficit's credibility, and the duration of government formation. He also points out a fiscal paradox where delayed budget approval, leading to a continuing budget (1/12th), can actually curb spending and yield better short-term fiscal results. The shekel is seen as the primary and most sensitive indicator of local political risk, followed by bonds, with equities being the least sensitive, except for sectors directly exposed to local regulation.