The Shekel: One of the World's Strongest Currencies

After a not too short period of stable exchange rates, and after forex traders had started to complain of boredom; the dollar suddenly plummeted over the past few days. Yesterday saw the greenback lose 2% against the shekel by the end of the day.

In the morning the dollar had already fallen below NIS 4, but then the Bank of Israel tried to stop the fall by making its announcement that it would continue to buy dollars - and deflate rumors that the central bank would stop buying the daily ration of $100 million in foreign currency it has been purchasing for the last 10 months.

Such rumors have been growing in recent days after TheMarker published an analysis on the bank's exit strategy to stop the purchases, as well as to reject claims as to what Karnit Flug, the director of the central bank's research department, said to Citibank traders. The announcement, along with a significant number of stop-loss orders at NIS 4, returned the dollar to the NIS 4.02 level at midday.

Stop-loss orders are instructions left by forex traders with their banks to close all their positions when the exchange rates cross a certain line - and cause them losses. For many traders who bet on the strengthening shekel, the psychological barrier was NIS 4. The shekel broke through the barrier again at the end of the day after the representative rate was set at NIS 4.017.

"The Bank of Israel was lucky yesterday, as both before and after the representative rate was set the dollar traded at less than NIS 4," said one trader.

The shekel is one of the currencies that has strengthened the most against the dollar this year: The second out of 176 currencies. Only Macedonian denar did better.

And why did the dollar drop so far in only one day? The banks' trading rooms reported on large sales of dollars by foreign banks and investors, which pushed the dollar down against the shekel. At the same time, these same traders reported quite a lot of interest and demand for long-term Shahar unlinked shekel-denominated government bonds.

The logic behind the sale of dollars over the past two days and the purchase of government bonds is this: After the price of shekel-denominated government bonds plunged on Wednesday to a level reflecting annual yields of 5.5%, foreign investors decided the bonds were a good investment. The demand for the bonds came from foreigners, and Israelis joined in - and yesterday this demand drove up the prices of the bonds.

The foreigners' strategy is known in the profession as the "carry trade" - a situation where investors, or traders, take out a short-term loan at low interest rates in dollars or shekels, and then turn around and invest the money in long-term bonds with a 5.5% return in shekels.

This difference in interests is their profit, and it lasts as long as conditions remain unchanged. Long-term Israeli government bonds look attractive to foreign investors also because of the gap in yields between these bonds and similar U.S. government bonds - a gap of over 2%, a record for recent years.

Will the dollar continue to fall? No one can predict short-term moves in the forex market, but one thing is clear: Stanley Fischer is very worried about what is happening. Over the past 48 hours the central bank has twice tried to convince the market that it will so anything in its power to prevent an uncontrolled strengthening of the shekel.

Based on past experience, Fischer has shown he can, and will, do quite a lot - including unexpected acts - to prevent the shekel from rising too high for the good of Israeli exporters. It now seems the exit strategy will now have to wait for calmer times.