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Flug Running Out of Options as Shekel Rallies: Israel Markets

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March 17 (Bloomberg) -- The Bank of Israel’s surprise interest-rate cut last month was another shot in a losing battle against one of the world’s strongest currencies.

The reduction of the benchmark rate to 0.75 percent is not only failing to weaken the shekel, which posted its fifth straight week of gains, it’s fueling a rally in the government bond market, according to Alex Zabezhinsky, chief economist at Tel Aviv-based Meitav DS Investment House Ltd.

“Investors are basically yawning at the Bank of Israel’s interest rate policy,” said Zabezhinsky. They “see that the gun barrel is emptying and that the shekel continues to strengthen. The falling interest rates are actually attracting some foreign investors to the bond market,” he said.

In a speech yesterday at the Interdisciplinary Center Herzliya, Governor Karnit Flug laid out considerations behind the February rate cut, including annual inflation below the midpoint of the 1 percent to 3 percent target, a slowdown in business sector output and a mixed global economic picture.

The shekel has gained 6.6 percent against the dollar in the past 12 months, making it the strongest non-European currency in the period, according to data on Bloomberg. The yield on Israeli benchmark bonds has fallen to a record low as investors bet the central bank will keep interest rates down.

A strong shekel endangers Israel’s economy because exports are equivalent to about 40 percent of gross domestic product. Israel has still outpaced most developed economies, growing an average of almost 4 percent in the past five years. Burgeoning gas production is further fueling the currency’s strength by pushing up the current account surplus.

Israel Investment

Foreign direct investment in Israel reached a seven-year high of about $12 billion in 2013, economists at Bank Leumi Le-Israeli Ltd. wrote. “The continuing trend of foreign direct investment in the economy and the current account surplus may support the continued strength of the shekel.”

The shekel’s strength has become exaggerated, said Zabezhinsky. “It can’t climb too much from here.” The currency appreciated 0.2 percent to 3.4576 a dollar by 5:13 p.m. in Tel Aviv.

Political tensions haven’t disrupted the market gains. This month, Israeli armed forces seized a ship they said was carrying Iranian-supplied weapons to the Gaza Strip, and the Gaza conflict flared again in an exchange of fire with militants.

The Tamar and Leviathan offshore natural-gas fields are expected to transform Israel into a fuel exporter. Savings on energy imports helped boost Israel’s current-account surplus to $7.2 billion in 2013, from $0.8 billion a year earlier.

Gas Speculation

“At the heart of it, the gas findings are attracting speculators,” said Zabezhinsky. “While the Bank of Israel has promised to neutralize the gas inflows, investors are betting that exports will fuel even more inflows.”

To offset the gas revenues, the central bank says it will buy $3.5 billion in foreign currency this year.

Flug will probably have to intervene more in the foreign-exchange markets, said Shmuel Ben Arie, head of wealth management at Pioneer Private Wealth Planning in Herzliya. The bank may not cut rates again because “it doesn’t see it being all that effective,” he said.

Shauli Katznelson, vice president of economy at the Israel Export & International Cooperation Institute, disagrees, saying there’s still room for further cuts because of the differential between Israel’s 0.75 percent rate and rates abroad, which are close to zero.

If the shekel does continue to strengthen, the central bank may just have to sit back and watch, acknowledging that the gains are driven by long-term economic changes over which it has little control, says Jonathan Katz, a Jerusalem-based economist at HSBC Holdings Plc.

“It’s not like another quarter of a percent will really prevent the trend,” Katz said. “If one looked at the toolkit of the Bank of Israel, there is really not that much left.”

To contact the reporter on this story: David Wainer in Tel Aviv at dwainer3@bloomberg.net

To contact the editors responsible for this story: Andrew J. Barden at barden@bloomberg.net Amy Teibel, Robert Lakin

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