| Rafi Gozlan, Chief Economist at IBI Investment House
| Highlights:
- The improvement in the markets following the recent interest rate decision was a development in an undesirable direction and sent Fed members to signal more accelerated restraint. The high inflation environment in the US will lead the Fed to a rapid restraint process even at the cost of a significant slowdown in activity, and the way there is through tightening financial conditions rather than improving them.
- The Bank of Israel has also signaled a faster rate of interest rate hikes than previously estimated, but in our opinion the domestic market is pricing an overly aggressive rate of increase. As the process of raising interest rates in the United States accelerates, so will the potential for raising interest rates in Israel.
- The emphasis on the supply side of the residential real estate market in Israel is understandable, and indeed there has been a significant improvement recently, but in order to curb the rise in prices, steps are needed to cool the demand side, which is a major factor in the sharp price increases over the past year.
Powell-led Fed members last week made some improvements to the latest decision. Powell apparently estimated that the messages that accompanied the interest rate decision were clear and “hawkish” enough, while the response in the markets was an improvement in financial conditions while the Fed was aiming for the other, i.e. to tighten financial conditions.
Therefore, in response to market developments in the past week, messages from Powell and other Fed members have increased regarding a higher dose of interest rate hikes, that is, 50 b.kr. 50 PS starting from the decision in early May, at the same time as starting the balance sheet reduction.
Although a significant part of the recent increase in the environment is due to the supply, the general situation in the US, which is characterized by a tight labor market and a high level of inflation, leads to the conclusion that the path to lower inflation will slow down demand.
To date, the markets have mainly reflected inflation concerns, with rising inflation expectations, but are gradually expected to reflect the moderating effects on activity due to the impact on disposable income and the monetary contraction.
Over the past week the bond market has expressed a sharpening of the tone of Fed members, with a high probability of raising 50 bp in May, pricing 125 bp in the next 3 decisions (i.e. the market expects two moves of at least 50 bp) B) and expect a cumulative increase of about 200 PS in the 6 decisions by the end of the year.
There was also an increase in the market’s assessment of the interest rate level at which the upward trajectory will end, to about 3% in the first half of 2023, with expectations that interest rate cuts will be recorded later this year remain the same.
Based on past experience, the Fed is expected to lead to prolonged restraint to a sufficient deterioration in financial conditions that will be accompanied by a significant decline in the inflation environment and an increase in the real interest rate environment.
Although the rise in nominal yields in the last two weeks has also translated into a rise in the real interest rate environment, they are still moving at a deep negative level in the short-medium term to redemption, so this trend is expected to continue until a moderation in the inflation environment emerges.
Uncertainty about the level of the nominal interest rate that will lead to a sufficient rise in the real interest rate plays a significant role in the rapid rise in recent yields, including a sharp rise in standard deviations in the bond market.
The pressure on the bond market may continue in the near future, but in our estimation it is in advanced stages, and is reflected in the unusual gap between bond yields and the Fed interest rate, which reached 200 basis points, a record level of the last two decades. Medium-long to redemption.
The probability that the Fed will be able to moderate inflation without a significant slowdown or recession is not particularly high, and the bond market is gradually showing this with the continued flattening of the curve, with a recent reversal in the 3-year to 10-year maturity range.
Also, the steepness between the two-year US bonds has dropped significantly and the gap has narrowed to just about 10 bp. Although this development is not a definite indication of entering a recession, it does increase the probability of this in the next one to two years.
Thus, we estimate that the recent recovery in risk assets is limited, and that they will find it difficult to develop a sustained positive trend as long as there has been no significant decline in the inflation environment.
Despite this, there has been a recent decline in the risk premium embodied in the leading US stock indices, to the low levels observed in the last decade, compared to a significantly higher risk premium in the leading Asian indices in Europe, further overweight support for these indices over those in the US.
| The Bank of Israel announces a series of interest rate hikes to begin in April, drawing attention to the development of underlying inflation
In Israel, too, the signal for an increase has risen, albeit moderately compared to that in the United States.
As part of the interest rate decision in February, the Bank is close in the coming months, and this was accompanied by an assessment of a slow and gradual rate of increase. Since the decision, there has been a step up in the inflation environment, both in practice and in expectations.
Although much of the recent rise reflects a shock to supply due to the sharp rise in commodity prices that is expected to lead to a slowdown in growth, the deep negative territory in which real interest rates are not commensurate with the economy and leads to a series of interest rate hikes starting in April, including May and July. At an interest rate of 1% -0.75% during the second half of the year.
Another important reference of the Vice-Governor was regarding basic inflation. Most of the increase in inflation in the past year has relied on imported inflation both on the part of commodity prices and on the side of supply chain disruptions, to which has been added the contribution of the government’s tax increase.
Thus, inflation less energy, fruits and vegetables and government measures rose by 2.7% in the last year, lower than the rise in the general index, 3.5%. A comparison with the basic inflation in the world, after deducting energy and food prices, also draws the same conclusion. The reference to underlying inflation is gaining importance at this time, as it is a shock to the supply side that entails mitigating effects on activity later on.
Therefore, although the rise in general inflation and inflation expectations are expected to lead to a start in the process of raising interest rates in April, the pace later on will be affected by the development of basic inflation, which has so far moved in the direction of a more moderate rise.
Beyond the expectation of interest rate hikes by the Bank of Israel in the second and third quarters, our local policy depends to a large extent on global developments, and on the extent of the Fed’s impact on the global inflation environment. That the sooner the Fed’s policy becomes restrained, a scenario that has recently been strengthened, the more limited the potential for local interest rate hikes will be.
Although the local inflation environment is low relative to the world and will be greatly affected by the expected restraint in the US, the domestic market continues to embody a very aggressive interest rate path. The local is sharper.
Although the recent rise in yields has been accompanied by some flattening of the curve, local steepness continues to be exceptional, reflecting a very high risk premium and potential for capital gains later in the year.
Inflation expectations have risen sharply in recent weeks due to the sharp rise in commodity prices. The structure of the expectations curve, which decreases from left to right, is consistent with the curves in the world, but given the lower inflation environment in Israel, and certainly the structural factors that support lower inflation in the medium term (cost of living, exchange rate), the inflation premium .
| The supply side does its thing, but in order to moderate real estate prices, a rapid cooling of the demand side is required.
Recent real estate data suggested a significant response from the supply side with a sharp increase in construction starts in the last quarter of 2021, which was also accompanied by a sharp increase in building permits. Building.
The experience of recent years shows that initial start-up estimates are tilted downwards on average close to 2000 per quarter, and this development has also accompanied the last quarters, so it is likely that the volume of starts in 2021 will eventually turn out to be higher. Thus, the cumulative updates to the data of recent years paint a picture according to which the volume of starts between the years 2016-2020 is around 56-57 thousand starts per year.
In contrast, when it comes to the completion of construction the picture is less encouraging, so the lag in relation to construction starts has widened. The explanations for this range from problems on the supply side (as shown by the trends survey – shortage of professional workers and problems with equipment and raw materials) and confidence regarding the continuation of high demand against the background of the jump recorded in the past year.
The demand for new apartments this year crossed the threshold of 70,000 apartments, thus bypassing the increase in construction starts. As the following graph shows, the excess demand (the gap between construction starts and the demand for new dwellings) has provided a fairly effective explanation for price developments over the past decade, and accordingly also explains the sharp rise in prices recorded over the past year.
Thus, while the main focus of the policy makers is the supply side, the conclusion that emerges from the data sharpens the need for a more serious approach to the demand side. For the steps taken during the crisis by the Treasury or the Bank of Israel have significantly accelerated demand, with policy makers’ statements regarding continued price increases alongside the sharp rise in credit, creating perfect conditions for galloping inflation in residential real estate prices.
Although the expected increase on the supply side is expected to gradually reduce the rate of price increases, in order to achieve a more effective effect, a rapid cooling of demand is required, which can also be achieved on the monetary side with interest rate increases, certainly in the current inflation environment. Beyond that, it is necessary to compare the terms of taxation for financial assets in the capital market, in particular with regard to the taxation of the current return (ie rent), and to provide incentives for closing the gaps between the start and the end of construction.
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