Moderating inflation supports shekel-linked bonds

Moderating inflation sup

The Central Bureau of Statistics will release the September's consumer price index (CPI) on October 15th. The index is expected to rise by 0.1% compared to the previous month, and 3.2 percent in the past 12 months. The following three indices, October, November and December, are expected to add a total of 0.2% to the annual inflation and set the 2009 Inflation at a level of 4 percent - a one percent above the Bank of Israel's (BoI) upper limit target range (1%-3%). BoI's Exit Strategy: Although the consumers' cost of living increased by 3.2 percent in the past year and is expected to climb further in the next few months, the central bank is not worried from inflation. Last week, the Bank of Israel announced that the interest rate for October will be unchanged at 0.75 percent after increasing it in the previous month. There are three main considerations behind BoI's decision to keep the rate unchanged. First, the bank estimates that inflation will moderate during the next year after the short-term effects of the increases in government taxation will weaken (mainly the recent increases in VAT and the water surcharge). The bond market certainly agrees with this view. Inflationary expectations of the next 12 months (which are derived from the capital market) reflect inflation lower than the midpoint of the central bank's range. In numbers, the expected inflation for next year is 1.7%, and the annual inflation in the next two years is expected to be slightly higher than the midpoint - 2.1%. The second parameter that affected BoI's decision was the existing growth risk and the uncertainty regarding the strength of the recovery in Israel and in the world economy in general. And lastly, the third affecting factor was the low levels of interest rates in the world leading economies, which are expected to remain unchanged for extended period. The interest rates' future direction is known. The rates will go up, but the main question is what will be the pace of the rate increases. According to market expectations, which are derived from the capital market, and Economists' forecasts interest rate is expected to rise in an unaggressive pace by 1.5%-2% in the next 12 months. Bond Market: This week, trading in the government bond market was in a positive trend with an additional flattening of the yields curve in anticipation of further increases in the near future. In the short-run, the positive trend is expected to continue among the shekel-linked bond due to rising concerns from dis-inflationary pressures the equity market after advancing 60 percent in 6 months. However, from a medium term point of view, the risk involved in investing in government bonds is increasing, mainly due to the yield levels in which they are being traded nowadays. This assessment derives first and foremost from expectations of a future rise in the interest rate environment and economic recovery which support investment in high risk assets. The writer is Chief Analyst and Strategist at Alumot-Sprint Investment House and also a regular writer for several leading financial papers and websites.