By Steven Scheer and Karin Strohecker
JERUSALEM/LONDON (Reuters) - Israel's war with Palestinian militant group Hamas has upended expectations of where Israeli short-term interest rates are headed as policymakers try to balance a sliding shekel and slowing economy with already above-target inflation.
Less than three weeks ago markets and analysts were predicting at least one more rate hike by early 2024, possibly as soon as this week, after an aggressive run of tightening that took the benchmark interest rate from 0.1% in April 2022 to 4.75% in May 2023.
But after Hamas gunmen from Gaza launched the deadliest attack on Israel's civilians in the country's history on Oct. 7, expectations swung to focus on sharp rate cuts before settling on a slightly softer easing path.
"The conflict uncertainty poses substantial risk to our rates outlook," said Morgan Stanley economist Georgi Deyanov.
He pointed to the lack of clear forward guidance from the Bank of Israel after it held rates on Monday for the third time in a row, saying it now had room to take a flexible approach given the "very high uncertainty" around the conflict and the effects on financial markets and economic activity.
Prior to the attack markets had priced in around a 40% chance of a rate hike to 5.0% at the Oct. 23 meeting, said Bank Hapoalim chief strategist Modi Shafrir, with the central bank already having warned it would act again if shekel weakness drove inflation higher.
When markets opened on the Monday after the attack, the shekel slid more than 2.5% in its biggest daily decline since the market turmoil of March 2020, the early days of the COVID-19 pandemic. The Bank of Israel launched a $30 billion intervention to shore up the currency and fend off inflationary pressure with price growth already running at 3.8% in September, above its 1%-3% annual target.
Still, by the following Friday, the market was expecting up to 75 basis points of rate cuts by year-end as Israel counted the economic toll on its almost $500 billion economy.
As its troops prepare for a ground invasion of Gaza that could widen the war, activity has all but stalled in Israel's tourism and construction sectors, while the call up of reservists is depleting the wider workforce.
The central bank has already trimmed its economic growth estimate for 2023 to 2.3% from 3% and to 2.8% from 3.0% for 2024 - assuming the war is contained.
The Tel Aviv Inter-Bank Offered Rate, or TELBOR, a proxy for interest rate expectations, shows markets are now pricing in just over 50 bps of rate cuts over the next 12 months.
However, Bank of Israel Governor Amir Yaron on Monday told reporters that rate cuts were unlikely during the war, following similarly expectation dampening comments the previous week from Deputy Governor Andrew Abir who said the immediate objective was defending the shekel.
"We thought the market was overreacting and exaggerating a rate cut in the (Oct. 23) decision, during the war," Bank Hapoalim's Shafrir said.
Yaron said Israel's risk premium, which has risen sharply, first needed to decline while market stability was paramount. He argued that other steps targeting deferred loan repayments were de facto monetary easing.
Credit default swaps - a derivative used to insure against a sovereign default - have risen from 60 bps pre-war to 149 bps on Tuesday. On Wednesday, they stood at 145 bps, data from S&P Global Market Intelligence showed.
The central bank's own economists project 50-75 bps of rate cuts in the next year. Prior to the war, markets had predicted that the benchmark rate would be lowered by at least 100 bps through 2024 as inflation returned to its target range.
Meanwhile, the Federal Reserve's higher-for-longer interest rate message is gaining traction, with U.S. 10-year Treasury yields - a key determinant for global borrowing costs - recently hitting a 16-year high of 5%.
Israel's next rate decision is due on Nov. 27 with markets currently expecting rates to be held, and the three-month TELBOR rate pointing to a 25 bps cut in early 2024.
"The Bank of Israel will ultimately need to ease policy, even as the indicated scale of easing appears less aggressive than the recent market pricing," said JPMorgan's Anatoliy Shal, who sees the benchmark rate at 4% by end-2024.
Policymakers, he said, would need to balance the need to support credit growth with the high risk premium and large fiscal response to the war, while also trying to contain secondary effects from supply shocks to inflation.
"Needless to say, uncertainty remains very high," Shal said.