Why Are the Israeli Markets Ignoring the Gaza War?

See the chart, showing the behavior of the shekel against the U.S. dollar in the last month, from just before Operation Protective Edge began. See anything unusual?

• Israelis stay home during Gaza war, further sinking airlines’ revenues
• U.S. issues travel warning for Israel, West Bank
• UN chief due in Israel to press for cease-fire
• Euro falls to 12-year low against the shekel
• Treasury, IMF confident Israel will weather war
• Tel Aviv’s young internationals struggle to keep the party going
• During cease-fire, Israelis head out to malls, restaurants, and beaches

No? Indeed there isn’t anything, but isn’t that weird?

Since the shekel became a freely traded currency 20 years ago, its exchange rate has been continuously controlled by the markets. It’s all about supply and demand. And when tensions mount and rockets start to fly, the financial markets – including the currency market – have always reacted. The shekel would typically sink against the dollar, to this or that degree. Once the tensions subsided, the shekel-dollar rate would usually return to its pre-conflict level.

That would apply to all the financial assets associated with Israel and its stability, not just the exchange rate. Stocks would drop, insurance futures against Israel going bankrupt would rise.

That’s the natural way of things in the financial markets. When bullets are flying, or may fly, and the outcome is unclear, the risk associated with holding Israeli financial assets increases, and traders react. The dollar rises against the shekel. Stocks and bonds drop. Hedging Israeli financial assets gets pricier. The same happened last year, after Washington threatened to bomb Syria because of its use of chemical weapons.

But not this time, even though Operation Protective Edge has the entire Israeli population involved because of the wider missile footprint. Not only isn’t the shekel falling against the dollar: It’s strengthened. The benchmark Tel Aviv-100 index of shares has gained nearly 1% since the hostilities began and the corporate bonds index gained a bit. Insurance on Israeli government bonds did increase a bit – they are pure risk contracts, after all – but barely. They moved a lot more when the United States was muttering about bombing Syria.

Apparently this time, market players think the whole thing will wind down quickly, without a particularly heavy price. They don’t see a danger of deterioration into regional war. Last Friday the dollar did pick up a bit against the shekel, closing the week at 3.429 shekels, possibly because Israeli ground troops went into Gaza on Thursday night.

But the big picture is that this time, the markets haven’t reacted. At least, not yet.

Why is this campaign different from all other campaigns? Why is Operation Protective Edge different?

“Traders have learned their lesson,” says one currency player. “During the previous campaigns they bought dollars to be safe and lost money after the campaign ended. This time they evidently decided to continue business as usual. As though there’s no war happening.”

Iron Dome, it seems, is protecting more than the people of Israel. It’s protecting their financial assets, too.

But that can’t be the whole answer, because not only didn’t the shekel weaken – it appreciated since the operation began. Did speculators decide this was the time to attack, betting that the shekel would continue to climb?

In the past, when conflict would flare up, so did conspiracy theories – that enemies of Israel were acting in the market to weaken the shekel and hurt the Israeli economy. Could that have been true?

No, according to data from the Bank of Israel. It hasn’t seen foreign bodies purchasing shekels (in net terms) since Operation Protective Edge began. Its figures show that foreign activity is more or less balanced, so it shouldn’t affect the exchange rate. If anything, the data show that Israeli institutional investors are the ones active in the currency market, and it may be their activity that has lifted the shekel this month.

The institutional investors, mainly insurance companies and investment banks, were apparently sick of losses that the appreciating shekel was causing them vis-a-vis positions in foreign assets, and some decided to hedge against its further appreciation.

A cynic might wonder why local institutional investors, using the public’s money, are hedging only after the dollar weakened to 3.41 shekels – in other words, why they didn’t do so earlier. But our point here is that the fact of buying protection is equivalent to selling dollars, so it lifts the shekel against the dollar.

Betting against Israel

In the short run, the investors' bet may pay off. If the campaign ends soon and if quiet can be maintained, we may find that the market traders spared themselves from losses by declining to hunker down in dollars this time, by refusing to shun “blue and white” assets.

But in the longer run, the gamble becomes more ambiguous. On the one hand, the Israeli economy has been slowing because global economic activity is sluggish. On the other, because of the costs and damage caused by Operation Protective Edge, we can expect the Israeli government to increase military spending at the expense of civilian spending.

The outcome will be a bigger government deficit and diminished GDP growth. The budget crunch will get worse. Everything will be harder. These are not things that support the shekel. Economists have already begun lowering their forecasts for Israeli growth. Bank Leumi, for instance, cut its growth forecast in 2014 from 2.9% to 2.7%.

At the end of the day, the shekel’s appreciation in the last year is mainly due to the belief among traders in Israel and the world that the Israeli economy is strong, and will grow faster than that of either the United States or Europe. Therefore, why not park money in Israel rather than in the dollar or euro, and enjoy interest rate gaps and capital gains?

If that belief is shaken and if interest rates on the dollar start to rise, as many think will happen, then the uptrend by the shekel may well stop.

Most of the foreign banks that indulge in currency forecasting have been saying the shekel is expensive, and that its equilibrium rate is more like 3.80 to the dollar (it’s about 3.40). Of course, betting on exchange rates is a fool’s gamble. But given the new challenges that the Israeli economy faces and what seems to be the political inability to handle them, and given the Bank of Israel’s ongoing ambition to support the dollar against the shekel by buying dollars in the currency market (it bought a lot last month) – maybe, this time, their forecast will prove true.