Shekel Weakens Sharply Amid Rising Risk Premium and Dollar Strength

In the past month, the Israeli shekel has sharply weakened against the US dollar, crossing above 3 shekels per dollar after previously trading below 2.8 in May. This decline makes the shekel one of the weakest currencies globally, surpassed only by the Norwegian krone and Russian ruble, both affected by falling oil prices. Moody Shapira, Chief Market Strategist at Bank Hapoalim, attributes the shekel's drop to several factors including a stronger dollar, increased Israeli risk premium following the US-Iran agreement, Bank of Israel interventions, Nasdaq declines, and interest rate differentials between Israel and the US.

The risk premium, measured by the spread between Israeli and US bond yields and CDS contract prices, rose significantly after the October 7 war, peaking at 140-160 basis points before dropping to around 49 basis points after the ceasefire agreement. However, it has since climbed back to approximately 54 basis points, reflecting ongoing geopolitical concerns. Interest rate expectations also play a role, with Israeli markets pricing a 2.9% rate in a year while US rates are expected to rise despite easing inflation forecasts.

Bank of Israel intervened in May by purchasing about $800 million to stabilize the currency and likely continued interventions in June. Governor Amir Yaron indicated that as inflation expectations approach the lower 1% target, the central bank may pursue faster monetary easing, potentially lowering interest rates. Meanwhile, institutional investors in Israel have recently increased their foreign currency exposure, reversing a prior trend, which may further pressure the shekel.

The shekel's performance is also linked to global stock markets, especially US tech stocks, which have recently declined. This dynamic forces Israeli institutions to adjust currency holdings to maintain exposure levels. Despite the recent weakness, economists note the shekel remains historically strong compared to the past 30 years. Bank of America recommends a long position on the dollar against the shekel with a target of 3.14 shekels per dollar over three months, warning to exit if the rate falls below 2.9.

Looking ahead, fundamental factors such as Israel's export surplus and significant tech investments support a strong shekel in the long term. However, if the shekel remains weak or depreciates further, inflationary pressures could rise over the next six months or more. Bank Hapoalim expects a modest interest rate cut in July but not aggressively so, as the shekel's weakness partially offsets inflation relief.

Summary: The Israeli shekel has weakened sharply against the dollar in June due to rising geopolitical risk, dollar strength, and institutional shifts in foreign currency exposure. Bank of Israel interventions and interest rate expectations also influence the currency, which remains historically strong but faces short-term depreciation risks.