Bloomberg News

Israel Bonds Signaling Fischer to Keep Interest Rates on Hold

June 28, 2011

June 29 (Bloomberg) -- The smallest difference in three months between yields on Israel’s inflation-linked and fixed- rate bonds is signaling the central bank may keep interest rates on hold without causing consumer price growth to pick up.

The so-called two-year breakeven rate, which reflects investors’ expectations for annual inflation during the period, fell one basis point, or 0.01 percentage point, yesterday to 273. The rate touched 271 basis points on June 23, the lowest level since at least March, data compiled by Bloomberg show.

Bank of Israel Governor Stanley Fischer held the benchmark lending rate at 3.25 percent on June 27 after 10 increases in two years to stem inflation. Slower global economic growth, falling commodities and gains in the shekel, which has climbed 13 percent against the dollar in the past year, will help contain price growth, the bank said.

“We are approaching the more mature stages of the tightening cycle,” James Lord, an emerging-markets strategist at Morgan Stanley in London, said in an interview. “We expect that inflation will gradually come lower, and inflation expectations should too.”

Yields on Israel’s fixed-rate bonds due in March 2013 fell 12 basis points this month to 3.8 percent, according to data compiled by Bloomberg. Inflation-linked bonds tumbled, sending yields on notes maturing in June 2013 up 26 basis points to 1.07 percent.

Target Range

At 273 basis points, the yield gap suggests traders expect that annual inflation will fall within the central bank’s target range of between 1 percent and 3 percent. The breakeven rate reached 352 basis points on May 9, the highest level in two months, as inflation remained at or above 4 percent every month since January.

The breakeven rate is 341 basis points in Chile, whose A+ credit rating at Standard & Poor’s is one step above Israel’s. The measure for the U.S. is 146.

Israel became the first country to raise interest rates since the end of the global financial crisis, increasing borrowing costs from a record low of 0.5 percent in August 2009. The currency has strengthened 10 percent since the end of 2009, helping curb prices of imports while eroding profit margins for exporters.

Higher interest rates and the currency appreciation are slowing the economy’s expansion. Israeli gross domestic product rose at an annual rate of 4.8 percent in the first quarter, after growing 7.6 percent in the previous period, the fastest pace since 2006.

Commodities Fall

Commodity prices, as measured by a UBS Bloomberg index, have declined 6.2 percent since the end of April, helping central banks stem inflation. Federal Reserve Chairman Ben S. Bernanke said on June 22 that the U.S. economic recovery has been slower than anticipated, while European policy makers are working on plans to prevent Greece from defaulting on its debt.

“The shekel appreciated over recent months and there was a decline in commodity prices,” the central bank said on June 27. “The impact on inflation of these items is expected to be felt in the future. In light of these issues, and the marked increase of risks in the global economy, it was decided to leave the interest rate at its current level.”

Israel’s Inflation will slow to 2.9 percent in the next 12 months from 4.1 percent in May, according to the average of forecasters surveyed by the Bank of Israel. Forecasters are predicting on average that the benchmark interest rate will be 4.3 percent in a year.

‘More Confident’

The Bank of Israel “seems more confident that inflation will decline to within the 1 to 3 percent target range by the first quarter of next year,” analysts at BNP Paribas, led by Paul Mortimer-Lee in London, wrote in a note to clients yesterday. “While it is likely that the bank will continue with its tightening cycle, we think that the current global environment warrants a more gradual approach.”

The yield on the benchmark Mimshal Shiklit bond due in January 2020 rose two basis points yesterday to 5.13 percent, or 133 basis points higher than yields of bonds maturing in 2013. The gap between the two has narrowed from 158 basis points in March.

The longer-maturity bonds will outperform the shorter-term securities as the central bank keeps inflation under control, according to Morgan Stanley’s Lord.

“The curve should flatten some more as the Bank of Israel tightens some more,” Lord said. “But this will be increasingly driven by a rally in the long end.”

Israel’s two-year interest-rate swaps, the cost investors can pay to lock in borrowing costs for two years, touched 3.85 percent yesterday, the lowest level since March 22, according to data compiled by Bloomberg.

--With assistance from Alisa Odenheimer in Jerusalem. Editors: Laura Zelenko, Brendan Walsh

To contact the reporter on this story: Ye Xie in New York at yxie6@bloomberg.net

To contact the editor responsible for this story: David Papadopoulos at papadopoulos@bloomberg.net


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