Dollar Surges to Highest Level of the Year Against Shekel

The dollar has reached its highest point against the Israeli shekel in seven months, erasing nearly all of the local currency's gains since the beginning of the year. In late May, the dollar had fallen to 2.8 shekels, its lowest point since 1993, with market expectations leaning towards further declines. However, the trend has reversed dramatically, with the dollar strengthening by a double-digit percentage since then. The current exchange rate stands at 3.16 shekels, the highest since late March.

One primary driver of the shekel's earlier strength was the U.S. stock market. Pension funds, provident funds, and insurance companies, holding substantial foreign assets, would sell dollars to maintain their desired foreign currency exposure when U.S. stocks rose. According to the Bank of Israel, these institutions sold a net of approximately $13.8 billion in foreign currency in the second quarter, up from about $5.3 billion in the previous quarter. Foreign residents also sold a net of about $6.4 billion in foreign currency during the same period.

Modi Shpirer, Chief Strategist for Financial Markets at Bank Hapoalim, explained that the shekel's appreciation began in late 2024, supported by a decrease in risk premiums and a shift in institutional investor behavior. "They held a relatively high exposure to foreign currency as of June 2024 and reduced it to about 18.5% by March 2026, a low rate compared to recent years," Shpirer noted. Harel Dotan, Investment Manager for Derivatives and Foreign Exchange at Menora Mivtachim, observed that institutional investors' foreign currency exposure, after dropping from about 25% to 18%, has recently risen to around 20%, making their hedging adjustments a significant factor in shekel movements.

The advantage of the shekel diminished as interest rate differentials between Israel and the U.S. widened. Initially, the Bank of Israel's interest rate was 4% compared to 3.5%-3.75% in the U.S. The Bank of Israel has since lowered its rate to 3.25%, while the Federal Reserve raised its rate in September to 3.75%-4%. This inversion means the dollar interest rate is now higher than Israel's, potentially reducing the attractiveness of holding shekels and increasing hedging costs. Dotan stated that hedging costs have increased due to these interest rate changes, with institutions employing various instruments to mitigate expenses.

The Bank of Israel also altered its market operations, purchasing a net of approximately $1.83 billion in foreign currency in May and June. The bank stated these actions were to maintain orderly market functioning, without setting a target rate. Shpirer suggested this intervention was also prompted by the rapid shekel appreciation, which could harm exporters and the high-tech sector, leading to both market intervention and an interest rate cut.

Hedging costs for dollar-shekel have surged, with the annual cost rising from 0.5% at the start of the year to 2.3% currently, according to Moti Azulai, Manager of the Foreign Exchange and Tradables Desk at Migdal Insurance and Finance. While not considered extreme historically, this is a significant increase from the average cost of 0.7%-0.8% over the past two years. Azulai also cited the 'basis,' a measure of the extra cost financial entities pay to exchange shekels for dollars in the futures market, as a factor increasing hedging costs, especially during periods of market volatility.

Despite rising hedging costs, investment managers generally recommend hedging a significant portion of U.S. investments. Raveev Karmi, CEO of Epsilon, part of The Phoenix Group, advises hedging between half and two-thirds of dollar exposure, noting that currency neutralization has proven beneficial over the past twenty years. For individual investors, Karmi suggests using exchange-traded funds (ETFs) or tracking funds that are pre-defined as 'currency-neutral.'

Globally, the dollar has also strengthened, with the dollar index rising about 3% from late May to late October. However, the dollar's appreciation against the shekel during the same period was around 12%, indicating that the shekel has weakened independently of global trends. Political uncertainty in October, following election results that did not yield a clear outcome, also contributed to the dollar's rise against the shekel. Shpirer believes political developments will be significant, with continued uncertainty potentially weakening the shekel further. The combination of rising oil prices, with Brent crude reaching $117 per barrel in late October, and a strengthening dollar against the shekel could increase inflationary pressures and complicate the Bank of Israel's ability to lower interest rates.

While some economists and investment managers maintain optimistic long-term forecasts for the shekel, Shpirer noted that Bank Hapoalim has shifted its short-term outlook from positive to neutral. However, both Shpirer and Dotan remain hopeful for the shekel's long-term prospects, citing strong fundamental forces that support its appreciation once uncertainty subsides. Key upcoming events include the Bank of Israel's interest rate decision on November 23, the Federal Reserve's decision on December 9, and the political system's ability to form a stable government.