We have developed two macro scenarios for Israel: gradual de-escalation and prolonged war. In both scenarios, inflation is expected to approach the target early next year, allowing the BoI to cut rates below what’s priced for YE2026. We believe it makes sense to engage in 15x18m vs 3x6m curve flatteners.
The first scenario, de-escalation, assumes a gradual reduction in military efforts starting in Q3 2025. In this scenario, we expect the vacancy-to-employment ratio to return to 0.75, similar to the pre-invasion period. Additionally, we anticipate that USD/ILS will decline and stabilize around 3.40 due to reduced fiscal pressure. The prolonged war scenario assumes the vacancy-to-employment ratio remains above 1, with USD/ILS staying steady at its current level.
Under the prolonged war scenario, our inflation outlook aligns with consensus and the BoI’s expectations. Inflation is projected to fall within the target range by Q3 2025 (Drax: 2.4% YoY), rise slightly in Q4 2025, and then stabilize around 2.2% from Q1 2026 onward. Despite the tight labor market, our interest rate model suggests that the BoI will gradually cut rates starting in Q4 2025, bringing 3M Telbor to around 3.2% by year-end 2026.
In the de-escalation scenario, the inflation outlook is more dovish, with impacts on inflation dynamics becoming evident from Q4 2025. Our models suggest that a more normalized labor market and a stronger currency would likely drive headline inflation below the target throughout most of next year. In this scenario, our interest rate model indicates the BoI may lower its policy rate to 2.75% by year-end 2026.
Both scenarios ultimately suggest a lower policy rate by Q4 2026 compared to the current market pricing of around 3.6%. In the de-escalation scenario, the BoI may opt to hold rates longer than priced, given risks from a tight labor market, and might wait until inflation falls within the target range before cutting. In the prolonged war scenario, the BoI may anticipate a normalization of the labor market and further inflation declines, leading to quicker rate cuts.
Our analysis suggests that engaging in STIR curve flatteners (15x18m vs. 3x6m) makes sense at -59bps. The core conviction is on the 15x18m ILS FRA receiver leg (3.75%), as it seems likely that the policy rate will be lower than what’s priced by then, even if the military effort continues. The 3×6 FRA currently trades 16bps below the fixing at 4.34%. We believe that the combination of (1) core and headline inflation running slightly above the 3% upper bound in the next three prints, (2) a very tight labor market, (3) no clear indication of de-escalation, and (4) high global uncertainty means the BoI may choose to remain on hold in its next two decisions.