Whence the shekel in 10 years?

According to the bonds market: NIS 4.53. Does that make sense?
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Q: What will the shekel's exchange rate be in 2011? Nobody could fairly answer that. So let's ask something else. Could the dollar trade in Tel Aviv at about NIS 4.53 in ten years? Meaning, only 7% above its rate today, and 3% above its rate after the September 11 terror attacks on the U.S.?

No way, most forex pundits will scoff. NIS 4.53 in a decade's time ¿ too low. Various currency oracles thought 2001 would be ending with the dollar at NIS 4.4 to NIS 4.5, then climbing above the NIS 4.5 barrier in 2002.

Okay, so maybe a shekel-dollar exchange rate of NIS 4.53 in 2011 isn't likely. But that's the rate synthetically created by doing the following exercise in bonds.

On Friday you could buy dollar-denominated Israeli government bonds, outside Israel, at a price reflecting yield to maturity of 6.55%. These are fixed-interest 10-year bonds trading at a spread of 1.7%, compared with 10-year U.S. T-bills carrying interest of 4.85%.

So far so good. But during trade yesterday, another Israel government bond, unlinked Shahar bonds, bore shekel interest of 6.5%. Now matters look a tad bizarre. When you have two series of bonds issued by the same party, of the same term, carrying identical interest, most investors would opt for the dollar-denominated securities, which provide protection from devaluation. The oddness lies in the identical interest on both series.

Such distortions can almost always be exploited. In our case, a strategy comes to mind: Buy the Israeli government bonds abroad while selling Shahar bonds short in Tel Aviv. Buying the government bonds overseas is easy enough although borrowing Shahar bonds to open a short position is more complicated, heavy investors and institutionals could carry it off.

The result is a 10-year forward contract on the dollar, as linkage to the dollar is the sole difference between the two bond types. How much will this forward cost? About 30 agorot per dollar.

That means that the dollar's exchange rate in ten years will be 30 agorot above its current rate, or: NIS 4.53.

Indeed, it is unlikely for the currency market to hover at these levels for so long. Speculators wanting to take advantage of the situation, or companies that use long-term forward contracts of the type, should go for it. There aren't many companies like that, but the Israel Electric Corporation and Bezeq phone company have been known to get into deals of the kind.

How did this situation arise, anyway? One possibility is that local investors overbought Shahar bonds, which indicates that their price will fall and yields rise, creating a spread between them and American T-bills. A spread favoring Shahars would provide return to compensate for the lack of linkage to the dollar.

Another possibility is that the price of Israel government bonds will rise and their yield will drop, but that still, their situation really is reasonable ¿ that they are trading close to 10-year T-bills, plus a certain premium, of course. In that case, yields on the Israeli bonds will drop only if yields on the American bonds do too.

There is yet a third, simpler, way the imbalance could be resolved ¿ if the shekel weakens against the dollar. Then Israeli bonds abroad, which are linked to the dollar, would become much more attractive.

Which of these three scenarios will end this interesting arbitrage display? The most likely development is a moderate fluctuation in all three directions: Long-term Shahar bonds will drop slightly in price, U.S. long-term interest rates will decline, and the shekel will weaken somewhat against the dollar. Indeed, in the last two days, the shekel has not broken through the NIS 4.22 resistance level.

Even some of the foreign banks playing on the Israeli currency market have begun to, cautiously, gamble again on the dollar gaining grounds against the shekel.