Israel's Rate Hold Amid Geopolitical Strains: Navigating Opportunities in Currency, Bonds, and Equity Markets

The Bank of Israel's decision to maintain its benchmark interest rate at 4.5% for an eighth consecutive meeting in early 2025, despite escalating geopolitical tensions in Gaza and Lebanon, underscores a strategic balancing act between inflation control and economic stability. This policy choice, driven by war-driven fiscal strains and supply chain disruptions, creates a unique investment landscape for currency, bond, and equity markets. Let's dissect the implications and uncover why now could be a pivotal moment to position for gains in Israeli assets.

Monetary Policy Stance: A Delicate Equilibrium

The Bank of Israel's rate hold reflects its dual mandate: taming inflation while avoiding a deeper economic slowdown. Inflation, though easing to 3.4% in February 2025 from a peak of 3.8%, remains above the central bank's 1-3% target. Geopolitical conflicts have exacerbated this challenge by disrupting supply chains, driving up import costs, and straining domestic labor markets.

Meanwhile, the fiscal outlook is grim. Defense spending has nearly doubled to NIS 118 billion in 2025, pushing the fiscal deficit to 9% of GDP and external debt to 76% of GDP. These pressures have already triggered credit rating downgrades—Moody's lowered Israel's rating to Baa1, while S&P and Fitch cut theirs to A. Yet, the central bank has opted to hold rates steady, prioritizing stability over aggressive easing.

Currency: A Test of Resilience

The Israeli shekel has been under pressure, depreciating 6% against the dollar since mid-2023. While geopolitical risks typically weaken currencies, the shekel's decline is also linked to inflation and the broader global flight to safe-haven assets. However, this creates an opportunity for contrarian investors.

Why Buy the Shekel Now?
- Relative Stability: Despite the wars, Israel's economy remains resilient, with tech and defense sectors outperforming.
- Central Bank Backstop: The Bank of Israel's policy credibility and foreign exchange reserves ($106 billion) provide a buffer against sudden shocks.
- Valuation: The shekel is undervalued relative to fundamentals. A rebound in global risk appetite or a ceasefire could trigger a sharp rally.

Bonds: High Yield, High Conviction

Israeli government bonds offer 7.5% yields on 10-year notes—among the highest in developed markets. This premium reflects geopolitical risks but also presents a compelling value proposition.

Investment Case for Gil bonds (Israeli government bonds):
- Interest Rate Outlook: With inflation expected to fall further, the Bank of Israel could cut rates by year-end, boosting bond prices.
- Diversification: Gil bonds have low correlation with global bonds, offering a hedge against regional volatility.
- Credit Risk Mitigation: Despite downgrades, Israel's access to U.S. aid and high-tech export revenues ensures liquidity.

Equities: A Sector-Specific Play

The Tel Aviv 35 Index (TA-35) has underperformed global benchmarks by 15% year-to-date, offering discounts in select sectors.

Top Sectors to Target:
1. Defense & Cybersecurity: Companies like Elbit Systems (ESLT) and Check Point (CHKP) are beneficiaries of rising defense spending and global demand for security tech.
2. Tech & Innovation: Israel's tech sector, including Mobileye (MBLY) and Check Point, remains a global leader. These stocks offer growth despite macro headwinds.
3. Real Estate: With inflation cooling, real estate stocks like Alexandria Real Estate (ALXN) (though U.S.-listed, tied to Israeli markets) could rebound as interest rates stabilize.

Risks and the Catalyst for a Turnaround

The primary risk is further escalation in Gaza or Lebanon, which could spike inflation and send the shekel into freefall. However, a ceasefire or diplomatic breakthrough—even a partial one—would likely trigger a risk-on rally, lifting equities and bonds. Additionally, a U.S. Federal Reserve pause or cut could reduce dollar strength, supporting emerging market currencies like the shekel.

Conclusion: A Time for Courageous Investments

Israel's financial markets are pricing in the worst-case scenario. The Bank of Israel's resolve to stabilize rates, coupled with undervalued assets across currencies, bonds, and equities, creates a rare opportunity for long-term investors. While geopolitical risks remain, the asymmetry of potential rewards—especially in defense/tech stocks and Gil bonds—is compelling.

Act Now:
- Currency: Accumulate shekel-denominated assets.
- Bonds: Buy Gil 10-year notes for yield and capital appreciation.
- Equities: Focus on Israel's tech and defense champions.

The time to position is now—before the geopolitical fog clears and prices rise.

Invest with conviction, but always manage risk.