Renewed political uncertainty around the Israeli government’s proposed judicial overhaul saw the shekel weaken the most among major currencies last week, leaving the Bank of Israel with little choice but to hike borrowing costs in coming months to hamper price growth.
While it has been difficult to directly link local economic challenges to the proposed judicial changes as the world is facing a global economic slowdown, the growing uncertainty around the legal overhaul in recent weeks is seen to be hurting the local currency.
The Israeli shekel last week fell about 2.3% against the US dollar, the biggest weekly loss among a list of major global currencies. The local currency weakened to 3.735 against the greenback, the weakest level since March 2020, amid renewed market concerns that Prime Minister Benjamin Netanyahu will revive plans to make contentious changes to the country’s judicial system after the Knesset on Wednesday passed the bi-annual 2023-24 state budget. Adding to this uncertainty, IDF Chief of Staff Herzi Halevi on Tuesday warned of a looming war with Iran.
“The shekel’s exchange rate has lost touch with economic forces — mainly the US stock market — and is affected by events in the local political and security arena,” Alex Zabezhinsky, chief economist at Meitav investment house told The Times of Israel. “Until the end of 2022, the Israeli currency had a high correlation with the S&P 500 Index, meaning that if the US stock index is up, the shekel is gaining and when it is down, the currency is weakening.”
“Now we are seeing a reverse trend,” Zabezhinsky added.
Last week, the shekel continued its underperformance with global technology stocks as the Nasdaq index gained 2.5%, its fifth straight weekly increase, and the S&P 500 also advanced. Since the start of the year, the shekel has weakened more than 6%. Over the past decade, the local currency has strengthened against the greenback as Israel’s resilient economy, a vibrant high-tech ecosystem, strong balance of payments, and a declining trend in public debt offset geopolitical and security risks.
To reflect the shekel’s recent depreciation, Goldman Sachs analysts on Monday revised their shekel forecasts as they “expect domestic political developments will remain in the driver’s seat for the shekel.”
“It appears likely that discussions on the judicial reform will soon resume. Coinciding with this, USD/ILS has diverged even further from its typical beta to global tech stocks,” Goldman analysts wrote in a report on Monday. “If market participants and tech investors continue to grow more concerned about domestic political developments and their impact on institutional quality, then risk premium may build further in the currency.”
Goldman cut its forecasts of the shekel to 3.70 and 3.60 against the greenback in the next three and 12 months, respectively, from 3.50 and 3.40 previously, adding that the investment bank expects “volatility around these estimates to remain elevated.”
The government’s legislative effort began in January and was temporarily suspended by Netanyahu in late March, given growing public pushback and uproar over his attempted sacking of Defense Minister Yoav Gallant. The announced efforts to reach broad consensus over the judicial overhaul bid convinced credit rating agency Standard & Poor’s (S&P) this month to affirm Israel’s favorable rating at AA- with a “stable” outlook, while citing “persistent domestic and regional political and security risks” as potential threats to the economy.
Moody’s Investors Service warned in April that the key trigger for lowering Israel’s credit rating outlook to “stable” from “positive” was concern that the planned changes to the country’s legal system would threaten the independence of the judiciary, which is crucial in particular in Israel.
A weaker shekel is a double-edged sword for the economy and is expected to hit the public with a double whammy. Depreciation in the local currency raises the price of imported goods such as food and gas and travel abroad and leads to higher inflation at a time when consumers are already grappling with rising costs of living. This in turn means that inflation will not cool as smoothly as hoped, forcing the Bank of Israel to further raise interest rates to dampen private consumption and demand.
That’s after the Bank of Israel last week hiked its benchmark interest rate for a 10th consecutive time, lifting borrowing costs by 25 basis points to 4.75% as it struggles to rein in inflation growth in recent months. Despite the efforts, inflation has been hovering above 5% in annual terms for more than six months, far above the government’s target range of 1% to 3%. The aggressive interest rate hikes have rapidly fueled the costs of mortgage and loan holders who are struggling to pay off monthly payments.
Both Meitav and Bank Hapoalim expect the central bank to act to tackle higher inflation with one more interest rate hike of 25 basis points to 5% in coming months as local political uncertainty led to shekel weakness. In the coming 12 months, they both expect inflation to ease to 2.9%.
“Without the political uncertainty surrounding the proposed judicial overhaul, we would have probably seen the shekel trading around 3.4 against the dollar and inflation 0.8% lower,” according to Zabezhinsky.