| Rafi Gozlan, Chief Economist at IBI Investment House
| highlights:
- The lagged effect of aggressive monetary tightening after a prolonged period of zero interest rates is starting to show. The high inflation makes the monetary policy more complex, and is characterized by injecting liquidity for the purpose of handling financial stability at the same time as raising interest rates to moderate inflation.
- The monetary policy in the world aimed at tightening the financial conditions, so that as long as they are not eased again, the need for a series of additional interest rate increases decreases. The expectations for a quick turn in the interest rate in the US towards an interest rate reduction in the middle of the year, are not consistent with the current situation, but with a significant deterioration in activity and financial conditions.
- The latest inflation data in Israel and around the world reinforced the assessment of “sticky” inflation. Inflation in Israel in the coming year is expected to reach about 3-3.5%, with a more balanced risk arising on the one hand from the potential devaluation of the shekel, against the background of the fear of the consequences of the legislation to weaken the judicial system, and on the other hand from the expectation of a deterioration in the global macro picture. The Bank of Israel is expected to raise the interest rate in the next decision on the 25th, when without a significant deterioration in the world, the high inflation environment will make it difficult to stop the rate hikes in the next decisions as well.
| The lagged effect of the rapid interest rate hike has begun to show
The crisis of confidence that has recently afflicted the banking system in the US and Europe is largely due to the lagged effect of the rapid monetary restraint that was taken in the last year due to the overheating that characterized most of the leading economies. The high inflation environment makes such a turnaround difficult and requires a sufficient deterioration in the situation to convince the central banks that inflation is under control and expected to fall to the target range.
The deterioration recorded during the last few days in the financial conditions does indeed work in this direction, but a prolonged deterioration is required to ensure a decrease in demand in such media that will lead to a decrease in inflation. Until then, the monetary policy will try to act through additional tools to maintain financial stability, and at the same time aim for a restraining financial conditions environment in order to moderate inflation.
An example of this was recorded last week with the increase in the Eurozone by 50 bp, during which the ECB emphasized that the inflation environment is too high, and indicated that at the same time, if necessary, it will activate tools to support the banking system.
Similarly, the Fed increased during the last week by approximately 300 billion dollars (in loans to the banking system and not through the purchase of assets, so it is not a quantitative expansion), launched another program (BTFP) for loans for a term of up to one year under very favorable conditions (which was used to a relatively negligible extent in the last few days), and at the same time it is expected to increase during the week if there is no further significant deterioration in financial conditions.
The latest inflation data in Israel and around the world have strengthened the assessment of sticky inflation, and for a return to the target environment, a significant decrease in demand will be required, including a deterioration in the labor market, a mix that characterizes a period of recession. The crisis in the banking system in the US and Europe has indeed been met by the policy makers, but the uncertainty created and the fear of the stability of the banking system and the deterioration of the macro picture, are expected to lead to a more conservative credit policy while tightening credit conditions and the availability of credit, a development that will lead to a slowdown in activity during the second half of the year.
The crisis in the US is focused on small and medium-sized banks, and the fear is that the withdrawal of deposits from them will expand, despite the full deposit insurance provided following the collapse of SVB (NASDAQ:). According to Fed data, the small- and medium-sized banks are collectively responsible for about 50% of the credit in most segments (consumer, business and residential real estate) and at a higher rate of about 80% in commercial real estate, so a shift to a more conservative credit policy will translate into a slowdown later this year.
The data for the month of February in the USA surprised upwards and, similar to the Eurozone, the higher than expected increase in core inflation stood out, a development that strengthened the assessment of “sticky” inflation. General and core inflation in the USA rose in the last two months at a rate of 0.5%-0.4% and the annual rate hovered around 6 %-5.5%.
The development of inflation continues to reflect a moderation in goods inflation compared to a high rate increase of over 7% in services inflation. Also, the indicators for the basic inflation environment, which examine the median inflation and the index minus the items with the unusual changes, continue to reflect a high inflation environment that moves close to 7%. This increase is mainly based on the strength of the labor market, and as long as there is no significant deterioration in it that will lead to a slowdown in the rate of wage growth and a moderation in demand, the high inflation environment will be maintained.
The fear of a crisis in the banking system in the US and Europe led to sharp volatility in the bond market in recent days, and a quick and sharp turn in interest rate expectations. If until a few days ago, due to the higher than expected inflation, the markets priced an increase of about 100 basis points in the interest rate in the US, including a high probability of a 50 basis point increase in the upcoming decision, then today the pricing is completely different and reflects a partial probability of an increase in the coming week, And even beyond a series of interest rate reductions since the middle of the year.
In our estimation, the Fed will raise the interest rate this week by 25 basis points, and like the ECB will signal determination to return inflation to the target and that the next decisions will depend on the data.
Looking ahead, alongside the development of inflation, monetary policy depends on the development of financial conditions, so that the more restrained they are, especially with regard to the cost of credit, the need for further interest rate increases will decrease.
In any case, the assessment that the lagged effect of the monetary restraint has begun to manifest itself is expected to limit the strength of the interest rate increase, and therefore limits the potential for the increase in yields. Therefore, at the current level of yields, the MA recommendation is indeed neutral, but a renewed rise in yields will be an opportunity to extend the portfolio’s MA.
The aggressive pricing in the government bond market again seems unusual in relation to the pricing of risk assets. Thus, the pricing for the transition to an interest rate reduction already in the middle of the year, in particular when the current inflation environment is very high and far from the target, is consistent with a considerable deterioration in financial conditions and a slide into recession, a development that will relatively quickly also lead to a decrease in the inflation environment.
However, the pricing in the stock market, with high multiplier levels and expected relative stability in profitability this year and a very low risk premium, are not consistent with a slide into recession. Also, the levels of corporate margins have increased recently, but they too, especially in the unrated bonds, are significantly lower than levels that characterized past recession periods. Therefore, in our opinion, the current pricing supports a continued defensive position towards the risk assets.
In addition, there is a gap between the expected interest rate trajectory in the US and the Eurozone, so that while pricing in the US reflects a drop in interest rates starting in the middle of the year, relative stability is embodied in Europe. Assuming that the global macro picture will indeed lead to a reduction in interest rates in the US, it is difficult to see the European Bank standing on the other side. However, in our opinion, it is the American market that has gone too far with the expectations of an interest rate reduction, both against the background of high inflation and against the background of the lower risk of a systemic crisis at the same time to the liquidity measures taken to improve financial stability.
| An increase of 3.5%-3% in inflation is expected in the coming year, but the risk of inflation seems more balanced
In Israel, the environment continues to be higher than expected and reinforces the assessment of “sticky” inflation. Thus, after during 2022, inflation in Israel was seen as low compared to the rest of the world, in recent months the gap is narrowing, when as far as basic inflation is concerned, the picture is quite the same as that in the USA and the Eurozone, with levels of about 5.5%-5%.
Core inflation in Israel is characterized by a high correlation with that in the Eurozone, so the upward revision of the core inflation forecast for 2023 by the ECB from 4.2% to 4.6%, in particular against the background of the weakening of the .
The consumer price index for the month of February rose by 0.5%, higher than the consensus estimate (0.3%) for the second month in a row, and slightly higher than our estimate of a 0.4% increase. The index without energy fruits and vegetables, and the index without energy fruits and vegetables and without government involvement, which are an indication of basic inflation, rose at a rate of 0.4%-0.3%, to an annual rate similar to that recorded in January, about 5.1%, slightly lower than the increase of the general index in the last year, 5.2 %.
The February index reflected, apart from seasonal factors (an increase in fruits and vegetables and a decrease in clothing and footwear), a horizontal price increase, with an emphasis on the service industries, which, as mentioned, reinforces the assessment of “sticky” inflation. Thus, although there was a moderation in the rate of increase in tradable inflation (0.2% monthly, and a decrease in the annual rate from 5.4% to 4.8%), but non-tradable inflation increased by about 0.6%, while the annual rate remained stable at around 5.5-5.4%.
Also, a certain contribution was recorded from the devaluation of the exchange rate (mainly trips abroad) and as long as the current levels are maintained (and of course if the devaluation increases) a higher contribution from this factor is expected in the next two quarters.
Looking ahead, we expect an increase of 3.5%-3% (3.3%) in inflation in the coming year. The increase in inflation is expected to be supported by the tight labor market, at the same time as continued price pressure from imported inflation resulting from “sticky” global inflation and the devaluation of the shekel’s exchange rate. However, if so far we have estimated that the risk of inflation has tilted upwards, it appears that the picture is becoming more balanced, mainly against the background of recent developments in the world that have raised the probability of sliding into recession in the later stages of the year or in early 2024.
However, inflation in the coming period is expected to be relatively high, so beyond the effects of the tight labor market it is also expected to be supported by the rapid depreciation recorded in the exchange rate of the shekel in recent months.
The developments in the exchange rate were conspicuously disconnected from the changes in the mortgage markets in the US, and the shekel is significantly affected by the fear of the consequences of the legislation to weaken the legal system and to change the nature of the regime in Israel, and in our estimation, as long as there are no signs of an agreed compromise, the pressure to weaken the shekel is likely to continue.
| An interest rate increase of 25 basis points is expected in the upcoming decision, and without a significant deterioration in the world the interest rate increase will continue
The higher than expected increase in the index, and more importantly the “sticky” inflation and the risk of accelerating inflation as a result of the depreciation of the shekel, will lead to the Bank of Israel continuing to raise interest rates. Regarding the upcoming decision, against the background of the crisis in the banks in the US and Europe, and the increasing dependence of the monetary policy in the US and Europe on developments and data, it is likely that the Bank of Israel will moderate the rate of increases, so that it is expected to increase by 25 bp to 4.5% .
Furthermore, under the assumption of our inflation forecast, the monetary committee is expected to see before its eyes an annual rate of around 5% in the upcoming decisions, so that in order to avoid further interest rate increases, a significant deterioration in the global macro picture will be required, and in the absence of such a deterioration in the coming months, the interest rate is expected to reach 5% -4.75% until the middle of the year.
In terms of pricing in the bond market, the local market raised the risk premium to a certain extent and only partially followed the decline in global yields. However, as long as the risk of weakening the legal system does not drop out of the question, the risk of a further increase in the risk premium of the Israeli economy is high, and hence The expectation is that the local assets will continue to underperform and support a defensive position in terms of the portfolio.
Also, the environment of expectations for inflation from the bond market of approximately 2.6% reflects, in our estimation, a relatively low inflation risk premium, both against the background of the sticky inflation environment and against the background of the fear of continued devaluation of the shekel, therefore supporting an overweight to the tight channel over the shekel.
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