Unusual warning for investors in Israel: on the way to a painful blow to the housing and stock market

Economists at the Psagot investment house conducted a weekly economic review in which they touched on the uncertainty regarding inflation in the US and the Fed's response, bond sales by foreigners and mainly by Japan and China, and an increase in bond supply in light of the continued growth in the US deficit.

It is well known that in August, markets are supposed to rest. Except for unnecessary slips of the tongue at the Jackson Hole conference, there is usually not too much exciting news in August, and markets are often in autopilot mode ahead of the last quarter of the year.

This year we are in a different situation where long-term US bond yields are looking for some kind of anchor point and not exactly finding it. Last week, the US Treasury sold bonds in the amount of $742 billion in nine auctions, and the week before $638 billion in T-Bills alone.

The yield at the 30-year auction stood at 5.216%, the highest since August 2001, and at the 10-year auction at 4.683%, the highest since August 2007, while during August it was also twice above 4.7%. Let us recall that only in February the 10-year yield stood at 3.95%. In our assessment, there are 3 main reasons for the rise in long-term yields in the US, and we will try to check whether these reasons are expected to continue to push yields upward in the future.

The first and main reason for the rise in yields is the uncertainty regarding inflation and mainly regarding the Fed's response to it. Warsh entered the position with the perception that the Fed talks too much, and accordingly canceled the forward guidance and plans to get rid of the Dot Plot that shows the interest rate forecasts of Fed members and reduce the frequency of public appearances by committee members.

Warsh's intention is to restore the Fed's ability to cause shocks so that the monetary transmission is stronger, but the practical meaning is that the market is required to price in both inflation that refuses to go down, a wider dispersion of scenarios, and a fear that the Fed will be willing to tolerate inflation above the target in order not to raise the interest rate. The price of this uncertainty is reflected in a higher risk premium in the long part of the curve, where the gap between the 30-year yield and the effective Fed rate has widened to 152 bps.

The second reason is outside the US. Capital flow data for June showed that foreign holders reduced their holdings by $72 billion to $9.3 trillion, with central banks and governments responsible for $70 billion of this, and their holdings fell to $3.78 trillion, a low since February 2024. The big story, beyond China which sold bonds worth $42 billion, is of course Japan which alone reduced $26 billion in June and $123 billion since February.

Unlike China, the Japanese sales did not stem from a decrease in appetite for American debt but simply from the need for dollars against the backdrop of the weakening yen, when on July 31 Japan intervened in the foreign exchange market in the amount of 8.45 trillion yen (about $53 billion) in one trading day, the largest daily intervention ever recorded. As already published, the next day the US joined the intervention in the yen market, for the first time in about 30 years, when the Fed sold euros from its reserves and bought yen, and the yen strengthened from 164 to the dollar on July 28 to 156.9.

In other words, the US paid out of its pocket so that Japan, the largest foreign holder with about $1.1 trillion, would not be forced to sell American bonds to support its currency. Needless to say, the move did not really work and the yen has weakened again since and stands at 159.2 yen to the dollar.

The third reason is supply. The total marketable bonds of the US government reached $31.4 trillion, an increase of $2.5 trillion within a year. The T-Bills balance alone rose by a trillion dollars to $7 trillion.

So far, the Treasury has pushed most of the fundraising to the short end and saved pressure from the long part of the curve, but last week the New York Fed announced that it would not carry out purchases to manage reserves from mid-August to mid-September, meaning its net T-Bills purchases are dropping to zero.

Such a drop in demand will make it difficult for the Treasury to issue in the short part and shift fundraising to the long ranges that are already struggling anyway to absorb the supply. The 10-year auction last week already closed at a higher yield than that recorded in the market just before it, for the first time since May.

Of the three reasons, the monetary factor is the one least likely to continue pushing yields further up. Canceling the forward guidance is a structural change that requires the market to demand a higher premium for holding long duration, but this is a correction that needs to be done once. Once the premium is priced, there is no reason for it to continue to expand every month.

In other words, it is a step jump and not a slope. What will change is the inflationary component within it, which will be re-priced at every index publication, and without a media anchor from the Fed, the volatility around every publication will be higher than what we are used to. The Japanese factor, on the other hand, does not look like it has exhausted itself at all. The interest rate in Japan stands at 1.0% and is still lower than inflation, meaning it is negative in real terms, and as long as this is the situation, the pressure on the yen remains in place.

An operation of $53 billion in one trading day buys the Japanese central bank days, maybe weeks, but certainly not quarters of industrial peace, and therefore the Japanese will have to finance the next round again, at least partially, from the reserves.

Even if the Fed's repo framework prevents Japan from becoming a forced seller, it does not turn Japan back into a buyer, and China continues to reduce dollar reserves at a methodical pace of $84 billion in the last 12 months. Another point worth noting is that while the holdings of central banks and governments fell to $3.78 trillion, the holdings of the foreign private sector climbed to a record of $5.52 trillion.

On the face of it, this sounds good, but the buyer who replaces the holder who is not sensitive to price is precisely the one who is sensitive to it, so he charges a yield for risks and uncertainty. As for the bond supply, the answer regarding the continuation is probably not economic and therefore it is difficult to determine. The supply will continue to grow as long as the deficit does not change and this will be determined at the ballot box and not in the markets, so until November this is simply a figure that the curve needs to absorb.

We will add to this the question of Trump's crypto reform which is supposed to create demand for T-Bills but is quite stuck so it is difficult to estimate where things are going. One can also add that the slope between 2 and 10 years stands at only 45 bps, low in historical comparison and suitable for a world where growth is slow. The AI revolution is supposed to lead to rapid growth but also to persistent deflation, so it is difficult to say what the curve should look like in two or three years.

Where does all this meet us? First of all, in terms of the American economy, the most immediate channel is the housing market. The interest rate on mortgages in the US is derived from the yields in the long part and not from the Fed rate, and therefore the rise in yields is translated almost immediately into a higher financing cost for home buyers.

Since most mortgages in the US are at a fixed rate, the pressure does not fall on those who already own a home but on new buyers and on mobility in the market, and therefore it accumulates slowly and consistently. The same logic applies to the administration itself, since any shift of fundraising from the short end to the long end fixes the cost of debt at the highest levels since 2001 for decades to come.

In the financial markets, the impact passes through the multiples. A risk-free yield of 5.27% for a 30-year term raises the risk premium that investors need to demand in risk assets and the burden, mainly on companies whose value relies on distant cash flows. This does not mean that stock prices must fall, but it does mean that it is harder for them to rise and that the margin of error in pricing is narrowing. In Israel, the impact is expected to be concentrated in the long end of the curve.

Historically, American yields have a material impact on the long ranges in the local market, while the short part is derived mainly from the Bank of Israel's policy. Therefore, even if the expectations for further interest rate cuts in Israel are fully realized, they will mainly lower short-term yields, while long-term ones will remain tied to what is happening in Washington and Tokyo.

Since so far the gap between the US and Israel has grown, it will be difficult for those who lengthen duration in Israel to explain exactly what they are getting compensation for, especially when the elephant of the fiscal problem against the backdrop of security needs is moving restlessly in the room. In accordance with all this, we continue to prefer the medium-short duration portfolio in the bond portfolio and do not see a good enough reason to lengthen it.