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Foreign investors, mostly hedge funds and investment banks, have sold shekel-denominated Shahar bonds worth hundreds of millions of dollars - and they are the people responsible for the drops in the bond markets and the rise of the dollar.

In response to the sell-off by the foreign investors - which continued yesterday - the long-term government bonds known as Shahars dropped over 1 percent, extending losses from the day before.

Stock indexes were also down sharply across the board yesterday. The TA-25 lost over 1 percent and the broader TA-100 dropped 1.1 percent. For the week, the TA-25 index of blue chips fell 1.5 percent.

At the same time, short-term zero-coupon bonds known as Makams have been losing ground over the past few days. One-year bonds are now yielding 3.8 percent, compared with under 3.6 percent at the beginning of the week.

Traders who are in regular contact with foreign banks and hedge funds investing in Israel felt that the foreigners are selling off shekel bonds due to increasing interest rates around the world, and the resulting decreases in yields. This has made other markets more interesting for these investors than Israel.

For example, two days ago European interest rates rose to 4 percent, compared with 3.5 percent in Israel. U.S. 10-year government bonds showed increased yields yesterday, reaching 5 percent, their highest level since August 2006.

"In light of the increases in interest rates around the world, many of the foreigners are choosing now to take profits they made in recent months in Israel, and transfer the money to investments in other countries. The result is a drop in bond [prices], but also a large demand for dollars. This is the reason for the rapid rise of the dollar in the last three trading sessions," explained one trader.

Tal Levy adds:

The dollar appreciated by more than 1 percent against the shekel yesterday to NIS 4.14. In late trading the dollar continued to appreciate against the shekel after the official representative rate had been set, crossing NIS 4.15. The greenback began its rebound two weeks ago. On May 14 it dropped to a low point of NIS 3.960. Since then it has appreciated by 3.8 percent.

The dollar began the year at NIS 4.225, however, so it's still 2.7 percent below that level.

The resurgence of the dollar should make it easier for the Bank of Israel to meet its inflation target for the year, which is 1 to 3 percent. The central bank had already admitted to fears of not meeting the target this year because of the shekel's appreciation.

However, in a review released yesterday, Morgan Stanley analyst Serhan Cevik warned that under the radar, inflation is there and it's strong, running at 4 percent once linkage to the dollar is weeded out. He counseled the Bank of Israel, not that it asked, to stop lowering interest rates.

The Bank of Israel is well aware that consumer prices have been rising, but the official figures is distorted by the exchange rate, and shows inflation to be negative or very low.