Bank of Israel unexpectedly hiked rates by 25 bp, to 1.75%, while markets were looking for no move. CPI inflation was 2.4% year over year in June vs. 3.0% year over year in May, and was the first time it was back within the 1%-3% target range of October 2009. 12-month inflation expectations, as surveyed by the central bank, was 2.7% in July vs. 2.6% in June, but has remained in the mid-2's for most of this year. While inflation appears to be under control, the real sector remains strong and so the central bank clearly felt compelled to continue normalizing rates. Leading index rose 12% year over year in May, the most since early 2008, while industrial production and export growth remain robust and unemployment continues to fall.

ILS is firmer on the news, and continues the rally in place vs. USD, since the early July peak in USD/ILS around 3.92. Break of the 3.84 area targets the June low around 3.79. Israel has solid economic fundamentals, which when coupled with higher interest rates, should attract investor interest. We see continued divergence for EM currencies in the third quarter, with markets discerning between those with strong fundamentals vs. those with weak ones.

RBI is the only other EM central bank meeting this week, and is expected to hike rates by 25 bp and continue the tightening process. However, a case can be made for a bigger 50 bp hike, as price pressures remain extremely high and call for a greater policy response.

Note RBI hiked 25 bp in an intra-meeting move. Intra-meeting move was seen earlier this year, when the RBI hiked 25 bp intra-meeting in March and then followed it up with another 25 bp hike at its April meeting. Inflation has stabilized, but remains at very elevated levels.

In May, industrial CPI rose 13.9% year over year, while rural CPI rose 13.7% year over year. On the wholesale side, WPI rose 10.6% year over year in June and is still accelerating.

The government hiked gas and diesel prices in June, so look for all the inflation measures to move higher in the coming releases. GDP growth is surging, up 8.6% year over year in the first quarter vs. 6.5% year over year in the fourth quarter, and so further tightening is warranted.

Despite the prospects of strong growth and higher interest rates, INR is the worst Asian EM currency in the third quarter so far and the only one that's down vs. USD. We remain nervous about the global backdrop, and so INR underperformance is seen continuing. Next target ahead for USD/INR is the May high around 47.75.
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