Israel is on its way to a historic gap with the US. What will this do to the shekel?

On the eve of the Fed’s decision to lower the interest rate for the first time since it rose sharply about two years ago, the gap with Israel stands at one percent in favor of the US. However, this situation is expected to change in the coming months: while the interest rate there is on the way down, and according to the forecasts will be around 3.5% at the end of the second quarter of 2025 , in Israel the picture is completely different.

Our interest rate is stable at around 4.5%, and as long as the war continues and the uncertainty is high it is difficult to see the situation changing on the horizon. If that is not enough, there are even factors in the market who believe that the Bank of Israel will have no choice but to take an unusual step and raise the interest rate even more in an extreme scenario. This, against the background of the renewed increase in inflation, which only this week reached an annual rate of 3.6% – above the Bank of Israel’s target. The increase in the government deficit and the lack of clarity surrounding the state budget also contribute.

From the shekel, through the mortgage holders to the stock market and foreign investors: what will happen if the interest rate in Israel is one percent higher than in the US? The last time this happened was sometime in 2013.

Will the shekel strengthen?

In general and theoretically, in a normal situation, the narrowing of the interest rate gap between the US and Israel should have a positive effect on the local capital market. A lower interest rate in the US should apparently weaken the dollar and strengthen the shekel. A stronger shekel is expected to lower import costs and moderate inflationary pressures. Another aspect is the movement of foreign investor funds to Israel: when the interest rate gap between Israel and the US is high, it is better to be exposed to a safer country that also gives a higher interest rate, assuming the other variables are constant. Therefore, as the interest rate gap narrows, this can support the entry of foreign capital into Israel.

But the situation in Israel today is different. The war is ongoing, uncertainty is high and almost no one can say what the situation will be in a year. Modi Shafferer, Chief Strategist, Financial Markets at Bank Hapoalim, explains that “There is no doubt that the reduction of the Fed interest rate and narrowing of the interest rate gap is significant, but the impact on the local capital market in terms of the dollar-shekel exchange rate, inflation and bond yields will be minor in the event that the interest rate gaps continue to narrow , and this in light of the fact that the security factor is the main factor that moves the direction of the dollar-shekel exchange rate.”

According to him, evidence of this came to light after the publication of the consumer price index at the beginning of the week, when the shekel was supposed to strengthen due to the surprise in the index and the estimates that the interest rate would not decrease, but it weakened. At the same time, government bond yields are also heavily influenced by both Israel’s risk premium and the inflation environment in Israel, which is accelerating, contrary to the global trend.

While a high interest rate supposedly supports the shekel, those who pay the price directly are many of the mortgage takers. Those whose monthly repayment is linked to the Bank of Israel interest rate, and has jumped in the last two years by hundreds of shekels. Those who expected that the situation would change soon and relief would be felt are likely to be disappointed.

The war is in focus

So what will happen if the interest rate in Israel is significantly higher in 12 months? On the face of it, the expected interest rate gap is in Israel’s favor and should support the strengthening of the local currency and benefit inflation. But even here Shafrir makes a reservation and emphasizes that in light of the challenging inflation environment in Israel, it is more correct to look at the interest rate differentials in real terms. As of today, the real interest rate in the USA for two years is 2% and the real interest rate in Israel is a little less than 1.5%, the advantage that the high interest rate gives to the shekel is disappearing.

In addition to this, in a review published last week by Bank Hapoalim, it was claimed that the interest rate gap in favor of Israel “can hold water as long as the war continues, but in our estimation, in the scenario of the end of the war, it will cause an increase in the shekel exchange rate, and a faster response from the Bank of Israel.” That is, the high interest rate with us because of the war and the uncertainty, that these will pass will also pass.

The bond anomaly

Rinat Ashkenazi, Chief Economist at Phoenix Investment House, agrees with the words of Shaffer from Bank Hapoalim and explains that in general the foreign exchange market is usually affected by a variety of factors, and in particular by the gap between imports and exports. But there is no doubt that in the recent period security developments are a major factor in its direction.

At the same time, Ashkenazi refers to the expected effect of the narrowing of the interest rate gap between Israel and the US on the bond market: “On the face of it, the reduction of the Fed’s interest rate and the narrowing of the interest rate gap with Israel is expected to put downward pressure on long-term government bond yields. However, conditions of uncertainty in the Israeli economy, which include, among other things, the complex fiscal situation, and the high inflation will likely offset the positive effect on the local bond market.”

In the bottom line, minus the security effects, the narrowing of the interest rate differential between Israel and the US would be beneficial to the Israeli economy to some extent. However, as the scenario of an escalation in the war in the north becomes more and more tangible and the uncertainty in Israel continues to be large and complex – it is difficult to assess in which direction The interest rate differences between Israel and the US are increasing.