Two different systems almost collided yesterday in Israel's money and foreign exchange markets. One, that makes decisions in Jerusalem, talked and explained; the other, that makes deals from offices in Tel Aviv, didn't listen. The result at the end of the day was further appreciation of the shekel, confusion, and questions about who said what, when and to whom, and in what circumstances.
Yesterday, the Bank of Israel decided to leave its interest rate unchanged for July, at 0.1%. On the face of it, a routine matter. The same happened in the past two months, and the market reacted with restraint, with none of the drama we saw on the foreign exchange market yesterday. Only yesterday's interest rate announcement was accompanied by a briefing by Governor of the Bank of Israel Karnit Flug and other Bank of Israel officials for financial correspondents. Although the bank had announced that such a briefing will take place every three months, it was enough, apparently, to generate expectations of a dramatic measure, such as a quantitative easing program.
Flug herself mentioned this possibility five months ago, when it looked as though the Israeli economy was in deflation. But anyone who had read the central bank's announcements since then, and up to last month, would have gathered that the quantitative easing idea was being shelved. Yesterday, the governor herself gave that impression official validity. Inflation is expected to rise, and is returning to within the target range. So the talk is no longer of deflation and lower interest rates, but of when the interest rate will rise.
In other words, the Bank of Israel completed a U-turn on monetary policy, and extraordinary measures such as quantitative easing will return to the agenda only in special circumstances, such as the turmoil that would ensue if Greece were to exit the euro.
Had the Bank of Israel made do with that, it might have been possible to explain the substantial strengthening of the shekel and the decline of the dollar exchange rate to NIS 3.77/$. But the things that were said in the briefing and that were publicized included two more elements that should have influenced the thought processes of foreign currency market players.
The first element is the Bank of Israel Research Department's forecast according to which interest rates in the Israeli economy will not change before the end of 2015.This forecast should be compared with the forecast of the Federal Open Market Committee in the US which sets dollar interest rates. The committee sees the Federal Reserve rate rising to 0.6% by the end of this year. If the two forecasts are combined, they mean that an interest rate gap in favor of the dollar will open up over the next six months. It should be stressed that these are not official forecasts by the Governor of the Bank of Israel or by the Federal Reserve, but they should still be given weight in considering how interest rates will develop. In the foreign exchange market, what counts is not the local interest rate, but the interest rate gap between two currencies.
The second element is the governor's remark at yesterday's press briefing that the shekel is "appreciated", i.e. over-valued, compared with the equilibrium level. Over-valuation ought to be a risk measure for anyone who intends to continue to gamble on continued appreciation of the local currency, and sometimes arouses expectations of a correction.
Both these elements were absent from the considerations of those taking part in foreign currency trading yesterday and today. This could be connected to the positions created in the past few days; it could be that, despite everything, the Bank of Israel will raise its interest rate soon and fairly rapidly. But there is the possibility that the market will take in what it refused to hear yesterday evening. For now, the Bank of Israel will continue to maintain the line it has set for itself, and those who will need to adapt will be the players on the foreign exchange market, each in his own way and according to his own considerations.
Published by Globes [online], Israel business news - www.globes-online.com - on June 23, 2015
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