All That Glitters / The Fear Effect

We already know what the next big news story will be in the forex market. The headline will be something along these lines: "Bank of Israel says will stop buying $100 million a day." The subhead will read, "But says will continue to intervene in the market as it sees fit."

The only things we don't know yet are when the Bank of Israel will say exactly that, and how the market will react.

What Bank of Israel governor Stanley Fischer will do, or not do, is the talk at watercoolers everywhere. But the reason the dollar has been sinking so low against the shekel, opening yesterday's trading day at NIS 3.78, isn't the Bank of Israel. It's that the dollar has been losing value against the euro in world markets.

When we look at the graph of the dollar against the euro, versus its behavior against the shekel, we find that what's setting the dollar's pattern vis-a-vis the shekel is its fluctuation against the euro.

This is the formula. Every time equities surge in world markets, the dollar weakens against the euro. Immediately, with no time lag, the greenback weakens against the shekel, too. In the months to come, the movements of the dollar in the international marketplace will be the main factor setting its exchange rate here, too.

The main factor, not the only factor. Local elements also matter.

Between June 21 and July 26, for instance, the shekel appreciated against the euro, albeit not by much - just 0.3%. Why? Here we have to look at the expectations of local players.

This is what they say: If the Bank of Israel is forced to raise interest rates because inflation is resurgent, then an interest rate gap will open in favor of the shekel. The shekel will then appreciate. Even if the Bank of Israel does stop soaking up dollars, as many are calling on it to do, the shekel will appreciate. Even if foreign investors start investing in Israel again, the shekel will appreciate.

It's almost as if the Israeli economy were going back a year in time to the pre-crisis era. Economic indicators are converging on their levels of a year ago. Stocks are rising, inflation is too, interest rates are going to be rising and the dollar is depreciating. Under the circumstances, isn't it likely that the exchange rate will return to about NIS 3.50 per dollar, the players wonder with a shiver.

Precisely because of their apprehension, investors, speculators and companies' financial managers are streaming in their thousands to protect their assets and future cash flows denominated in dollars. They're buying "protection" against further appreciation of the shekel, using options and other futures contracts. Anybody who has to sell dollars and other foreign currencies in the coming weeks is simply doing so now instead.

These herd actions create self-fulfilling prophecies. Buying protection against the depreciation of the dollar is equivalent to selling the dollar and drumming up demand for shekels. The result: The dollar's dive steepens.

Indeed, currency traders report this week that orders to sell dollars and buy protection against its further fall are coming from all directions: Israeli banks, foreign banks, Israeli and overseas investment funds, capital market animals and companies. Everybody's selling foreign currency.

When will it stop? That depends on what happens in the international markets in the days to come, and when the Bank of Israel stops buying dollars every day.