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Thursday, February 26, 2015

Israel Enters the “Currency Wars”

On February 23 the Bank of Israel surprised the financial markets by cutting its base interest (equivalent to US Fed funds) rate to an all-time low of .1% and even indicated it would consider further "easy money" policies  through “quantitative easing. Thus it has joined the group of nations in a monetary easing phase while the Federal Reserve has ended quantitative easing and is expected –at some time in the near future—to raise rates. Such policies almost always have the effect of weakening a currency against those with a lower interest rate…as we have seen in the $/Euro rate. Hence the countries in the monetary easing mode are seen by many as in a “currency war” of currency depreciation vs. the US dollar to boost exports

The market reaction would not surprise anyone who has watched as central bankers around the world have cut interest rates. The Tel Aviv stock index hit a record high --after Germany, Japan and the total World Stock Index did so during the last couple weeks-- and bond prices jumped putting the yield on the ten year government bond down to 1.75%. The Israeli shekel (NIS) weakened immediately against the dollar and at the end of local trading on the 24th was at 3.9520 /$ vs. 3.8580 the previous day (based on the Bank of Israel data).

While the market movements: central bank easing, higher stocks, higher bonds/lower yields and weaker currency have been mirrored across the world, the Bank of Israel action has a significant difference. Most interest rate cuts have been primarily in response to recessionary conditions.  The recent economic growth numbers in Israel have been very positive.  Israeli GDP growth is strong at 7.2% (annualized) in most recent data   although the 2.9% GDP growth of the last year—a period that included the Gaza war and a massive drop in tourism-- was the weakest since 2009.The January inflation rate (CPI) declined by .9% but the central bank does not forecast future number to show deflation—although it is a concern.

What sets the Bank of Israel policy apart from the rest of the world’s central banks is the explicit mention of targeting a weaker currency. Certainly the Euro has weakened due to easing policies by the European Central Bank (ECB) and the same is the case for the Bank of Japan and the Yen. But neither of those central banks has officially acknowledged that a weaker currency—which helps exporters—is a goal of policy. It is impossible to target both interest rates and exchange rates: money flows to the higher yielding currency. Hence a weaker Euro and Yen in response to central bank easing designed primarily to stimulate local economic activity whether or not it has been identified as a major policy goal.

The Bank of Israel on the other hand seems to be doing the opposite targeting the exchange rate through lowering rates even without a need to stimulate local economic activity. This is understandable given the small domestic economy and the export intensive economy. The Bank of Israel has made clear that even a short term period of dollar weakness /NIS strength is a not only a concern it is a major rationale behind the rate cut and could lead to “unconventional methods” in future monetary policy.

From the Bank of Israel press release giving the rationales for cutting interest rates:
This month, the shekel continued its appreciation, strengthening by 2.6 percent against the dollar, and by 3.3 percent in terms of the nominal effective exchange rate. After a depreciation of 10.4 percent between August and December in the effective exchange rate, there has been an appreciation of 7.6 percent since December, so that the cumulative depreciation since August has only been 2 percent. Continued appreciation is liable to weigh on growth in the tradable industries—exports and import substitutes.

And later in the press release:
The Monetary Committee is of the opinion that in view of the increased rate of appreciation, and its possible effects on activity and inflation, reducing the interest rate to 0.1 percent is the most appropriate step at this time in order to support achieving the policy targets.

The Deputy Central bank governor was even more explicit
 Bank of Israel Deputy Governor Nadine Baudot-Trajtenberg said while the central bank was "relatively comfortable" with its 2015 growth forecast of 3.2 percent "we needed to ensure that no further (dollar-shekel) depreciation takes place."
"We had concern that looking forward, without the extra push, we would not necessarily maintain our growth estimate," Baudot-Trajtenberg said in an interview with Reuters 

NIS/$ (mm/day year format)
 Looking at the graph above (dates are in European format day/month/year) of the NIS/$ rate one can see how sensitive to the exchange rate changes the central bank is. Despite the large depreciation of the shekel since August, the slight retracement of the exchange rate was enough to concern the bank
As the Israeli newspaper Haaretz reports 
. Against the dollar, the shekel ILS= weakened by 15 percent between July and late January but reversed course and gained 2.6 percent in the month since the prior rates decision. More important to the central bank, the shekel's effective exchange rate had depreciated 10.4 percent between August and December but appreciated 7.6 percent since then.

Below is the NISl/Euro exchange rate where one can see that the aggressive easing policy by the European Central Bank has caused a sharp fall in the Euro/Shekel exchange rate hitting record highs for the NIS vs, the Euro.. With the European Union Israel’s largest export market it is clear that the Bank of Israel would have an interest in slowing the Shekel’s rise against the Euro, That will be a more difficult task as the Euro has been in a period of currency weakness due to its aggressive policy of monetary easing one that is expected to continue in the foreseeable future. 

NIS/Euro Exchange Rate (dates in mm/dd/year format)

Interest rate differentials are often a key determinant of exchange rates. This has often been true for the NIS $ exchange rate. during the period of aggressive easing by the Fed  the NIS was far stronger than current rates. As the Federal reserve lowered rates and the interest rate differential moved in favor of the NIS money flowed in from around the world into the shekel as it became one of the favorites of traders/investors interested in the “carry trade” moving money to higher interest rate currencies Previous Bank of Israel Governor (and now US Fed Governor ) Stanley Fisher followed a policy of central bank intervention  against a stronger shekel attempting to keep the exchange rate at a 3.40 to 3.80 range level.

With the latest rate cut to .1%  and ten year government bond yield of 1.75%, there is little room for a “carry trade” to profit from an interest rate differential vs the US $. Thus one factor that would lead to a stronger NIS no longer exist. There will be next to no likelihood of any speculative capital inflows into the shekel driven by interest rate differentials.

In fact the opposite is likely to be the case. Israel seems to be on the easing side of monetary policy alongside the European central bank and has even indicated it might engage in “quantitative easing” at some point. The next move by the Federal Reserve will be to raise interest rates with many analysts looking for that to happen as early as June. There is a large inflow of $ into shekels related to development of natural gas fields and this would accelerate when/if exports begin. But the central bank has been selling $ into the market to offset these inflows for a considerable amount of time already.

The combination of an easing monetary policy in Israel, a move to raise rates by the US and the Bank of Israel;s expressed desire to keep the shekel weak would argue for the Shekel to trade at current levels or weaker in the foreseeable future. The rate has seldom held much above the NIS 4.00 rate and many analysts see a move above that as unlikely citing “resistance”. But exchange rates are notoriously difficult to forecast. They often have a strong momentum factor. And rates seen by the market as “resistance” often cause strong market reaction in the same direction of the momentum when those “resistance “levels are broken

Has Israel entered the currency wars?  Here are the views of two analysts 

From  Bloomberg

The rate cut comes amid “a global currency war in which Israel cannot allow itself to lose its global competitiveness,” Shlomo Maoz , chief economist at S.M. Tel Aviv Investments Ltd., one of the three economists who predicted a rate cut, said by phone after the decision. It “signals to the market that the Bank of Israel will not allow an appreciation of the shekel” until the world economy rebalances, he said.

Tamir Fishman CEO Eldad Tamir writes, "The global currency war entails substantial steps to preserve a reasonable level of growth in Israeli exports, which are the cornerstone of the Israeli economy. In our view, if the figures don't improve, there could be a further interest rate cut, and we could even see the start of a quantitative easing program."

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