Whoever thought that the Bank of Israel's decision to cut the interest rate would halt the appreciation of the shekel got it wrong. The shekel strengthened sharply today and the Bank of Israel set the representative shekel-dollar exchange rate down 1.651% at NIS 2.859/$ and down 1.571% against the euro at NIS 3.326/euro. In late afternoon inter-bank trading, the shekel strengthened a further 1.02% to NIS 2.824/$ and a further 1.43% against the euro to NIS 3.301/euro.

The message received by the market after the interest rate decision and the interviews given by Bank of Israel Governor Prof. Amir Yaron was clear — the Bank of Israel will not intervene aggressively in the foreign exchange market and certainly not through direct intervention and the massive purchase of foreign currency.

Yaron's remarks indicate that inflation considerations are dictating policy. He told "Globes," "I don't dismiss the impact of the dollar exchange rate on exporters lightly, but it must be borne in mind that the central bank is not meant to change basic economic forces. In principle, intervention is part of the Committee's toolbox, but it is focused on specific, temporary situations of inflation, chiefly very low inflation, and on ensuring that the market functions properly."

In general, anyone reading the Monetary Committee's reasons for the interest rate decision may get the impression that the interest rate in the economy has remained unchanged, as happened in the two previous decisions. Thus, the Bank of Israel notes at the beginning of their reasons for the decision the geopolitical uncertainty in the local and global arenas, alongside the sharp increase in the inflation environment worldwide. In addition, the bank notes that the Iran war led to a 3.3% contraction in GDP (on an annualized basis) in the first quarter, but this was low compared with previous forecasts and the contraction of the economy following the campaign against Iran last June.

Given that the Bank of Israel actually cut the interest rate, these figures seem to be a defensive statement as to why the rate cut was not more drastic. Since March, there has been an 8% appreciation of the Israeli currency against the US dollar. This trend is hitting the domestic export industry hard, but at the same time constitutes a deflationary factor, as it lowers the costs of imported products. This decline in prices supports the economy's ability to demonstrate stability in the inflation target environment, thus paving the way for further interest rate cuts.

Therefore, many in the market believe that the rate cut decision will support the continuation of the shekel's appreciation against the leading currencies — a trend that was reflected in the weakening of the dollar against the shekel today — the day after the decision.

Ayalon Insurance and Finance SVP and investment division director Tamir Hershkovitz says, "The main insight I take from the interest rate decision and the committee's announcement is that the exchange rate is a secondary matter of low significance. It seems that the Bank of Israel treats the shekel-dollar exchange rate as if we were at a rate of NIS 3.88/$ and not NIS 2.88/$. Bottom line, exporters have been left alone in the field. The road to a rate of NIS 2.8/$ has been paved."

Hershkovitz is not alone. Another source in the foreign exchange market tells 'Globes," "The real interest rate in Israel is the highest in the West. The local market is already hot and a lot of money is flowing into it. Why should we additionally give a reward of almost 2% real interest?"

There are also those who back the Governor's decision. Ronen Menachem, chief markets economist at Mizrahi Tefahot Bank says, "Anyone who reads the committee's explanatory statements understands that they could have been appropriate for both the decision to leave the interest rate unchanged and for its reduction. On the one hand, there is the deflationary risk that is associated with the strengthening of the shekel, which is currently continuing. On the other hand, there is the inflationary risk that stems from the sharp increase in energy prices and the rate of inflation worldwide, with the concern that this inflation will be imported into the domestic economy." He thus believes that this is, "a reasonable and balanced decision, within a framework of very clear risk management."

Even if the Bank of Israel uses the tools at its disposal, including sharper interest rate cuts or active intervention in forex trade, its ability to influence the market is more limited than before. One of the main reasons for this is the huge volume of assets managed by institutional entities, which carry out hedging operations worth tens of billions of dollars for their foreign portfolio.

What is this hedging? These are financial transactions (usually with international banks) designed to protect their portfolios from fluctuations in the exchange rate. In practice, this mechanism acts as a "movement amplifier" for overseas markets: when US stock markets rise, the value of the institutions' foreign assets soar, and to maintain the risk level, they are forced to carry out massive sales of dollars and purchases of shekels. This activity creates constant pressure for the appreciation of the shekel and offsets the Bank of Israel's attempts to weaken it.

Since the end of March alone, Wall Street has been soaring, with the S&P 500 up nearly 20% and the Nasdaq up almost 30%. These strong gains have increased the need for accelerated hedging, which has supported the historic decline of the dollar to NIS 3/$ and below.

The hedging effect combines with another powerful mechanism — the rebalancing of institutional portfolios. When overseas stocks record sharp gains, they exceed the maximum exposure threshold set for them in the portfolio (for example, up to 50% of assets). To return to the permitted levels, Israeli institutional investors must sell foreign stocks, convert the dollars they receive into shekels, and repatriate the money. The combined result of the two mechanisms is a massive wave of shekel purchases, which continues to push appreciation and neutralizes the Bank of Israel's policy tools.

Menachem says, "The interest rate is a short-term tool, while the exchange rate is affected by a long list of factors. A situation could arise where the interest rate falls by 0.25%, 0.5%, or even 1%, and we still see the shekel strengthening. If the US stock markets continue to rise as a result of optimism or positive financial reports, the increase in institutional exposure abroad will force them to convert dollars back into shekels. Such a move would completely offset the effect of the interest rate cut."