Monex Europe: Bank of Israel has sufficient reserves to prevent full-blown currency crisis

19 oktober 2023

Given that broader markets have so far traded with a sense that the war between Israel and Hamas is unlikely to escalate into a conflict that destabilised the wider Middle East, it was a little surprising to see the pace of Shekel (ILS) depreciation accelerate on Monday, though this sell-off has subsequently begun to ease.

It was also notable, however, that the rally in USDILS through the 4.00 handle coincided with an influx of trade recommendations to short the shekel on the prospect of an escalation that induced premature rate cuts from the Bank of Israel (BoI). In our view though, any rate cuts are unlikely, with the BoI actually looking to contain shekel weakness with FX tools, a point seemingly confirmed by recent BoI commentary.

It is instructive that, looking back at similar episodes of fighting, these have ultimately seen relatively limited impacts on both the currency and the economy in the long run, despite outbreaks of shorter-term weakness. Therefore, given this history and the Bank of Israel’s ability to temporarily offset market forces, we think expectations that the shekel will continue to depreciate at an accelerated pace are unfounded at present, even in spite of the recent sell-off.

Admittedly, there remains risk that this situation escalates into a broader regional conflict, despite recent diplomatic efforts. This could eventually see the shekel trade significantly lower than current ranges such that ILS shorts may provide a profitable risk-reward profile on a tactical basis. Even so, we remain sceptical of this view, especially given that the extent of ILS depreciation under this scenario is hard to predict in advance, ultimately being dependant on the BoI’s preference to contain any shekel weakness.

On this point, it is notable that the BoI has already announced $45bn of FX interventions to temper the immediate sell-off in the shekel. Moreover, sitting at just shy of $200bn, the central bank’s FX reserves are considered plentiful by conventional standards – this would cover over two years of Israel’s imports under normal circumstances, and based on the IMF’s 2022 projections, would amount to four times Israel’s gross financing requirements per year. For this reason, we don’t think it is a question of whether the Bank of Israel ultimately has sufficient firepower to stabilise the currency, but instead their appetite to do so.

Given these resources, it may raise some eyebrows that USDILS has continued to climb through this week, albeit at a slower pace. But we think that this is a case of supply and demand imbalances that are likely to normalise, provided the situation does not deteriorate further. Even in the event of escalation, we think the BoI has sufficient reserves to prevent a full-blown currency crisis, especially as significant financial inflows from abroad will likely support the shekel. Not to mention, in the extreme case, we also think the US Treasury may order the Fed to open up swap lines with the BoI, although we are a long way from this eventuality materialising.

While it is hard to confidently call how far ILS will fall, we are sure that the BoI are unlikely to cut rates anytime soon

One thing we do not expect any time soon though, are rate cuts from the BoI, especially given the counterproductive impact this would have on weakening the shekel just weeks after mobilising reserves to defend the currency. This is especially pertinent given the renewed rally in Treasury yields, which is placing high beta FX back under pressure, and domestic inflation which remains above the BoI’s 1-3% tolerance band.

In this context, it is unsurprising to see BoI policymakers speak out in defence of the shekel in recent days, stating that monetary policy is likely to remain on hold for the foreseeable future to provide 'maximum certainty for the economy and the public at this time', suggesting that a weak shekel is the primary upside risk to inflation. This hawkish tone has effectively reduced speculative positioning on rate cuts from the BoI. We think policymakers will remain wary of escalation triggering a sharp selloff in the shekel going forwards, with the BoI instead focused on steadying the shekel and preserving financial stability as the situation continues to unfold, meaning another leg lower for the shekel is unlikely in our view.