VAT Cutback Plan Weakens Bond Market

NEW YORK (Bloomberg) -

Prospects of a housing tax cut have slammed the brakes on a local currency bond rally as investors bet the plan signals an end to Israel’s monetary expansion.

The yield on the country’s shekel-denominated bonds due March 2023 climbed five basis points since the government said March 18 it may scrap value-added-tax (VAT) for some first-time buyers in a bid to boost home ownership. That compares with a nine basis-point drop for Middle East bonds, according to JPMorgan Chase indexes. Israeli notes returned 14 times the regional average last year, according to data compiled by Bloomberg.

“We are likely to be at the end of the local bond rally,” David Reznik, head of fixed-income research at the Leumi Capital Markets division of Tel Aviv-based Bank Leumi Le-Israel, said by phone April 2. “The housing proposals will have an expansionary fiscal impact, boosting bets interest rates won’t be cut further and both are negatives for the local debt market.”

Finance Ministry’s chief economist Michael Sarel resigned in protest March 19 at the proposed tax cut calling it “completely wrong from every viewpoint,” while Bank of Israel governor Karnit Flug opposes the move because it may spur house prices, which soared 80 percent between 2007 and 2013. Investors piled into local debt in the past year as the central bank cut interest rates three times in a bid to curb the soaring shekel, spur exports and stem unemployment.

The yield premium investors demand to hold Israeli 10-year bonds over similar-maturity U.S. Treasuries was at 69 basis points yesterday, compared with a 12-month average of 111 basis points, data compiled by Bloomberg show.

“The local government debt market is expensive and looking ahead we could see underperformance,” Alex Zabezhinsky, chief economist at Tel Aviv-based Meitav DS Investment House Ltd. said by phone on April 2. “The gap narrowed to a level which doesn’t reflect the risk of the state of Israel.”

The cut in housing tax will mean a fall in government revenues, he said, pushing the budget deficit beyond the target of 3 percent of gross domestic product. Finance Minister Yair Lapid proposed eliminating the 18 percent VAT for first homes priced at not more than 1.6 million shekels ($459,809).

The Israeli economy is expected to grow 3.2 percent this year, slowing from 3.3 percent last year, the International Monetary Fund said yesterday, as the impact of first-time natural gas production from the Tamar off-site field diminishes. Unemployment may climb to 6.7 percent from 6.4 percent last year.

Some traders are still betting rates may be lowered. One-year interest rate swaps, an indicator of interest rates over the period, were at 0.68 percent yesterday, below the central bank’s benchmark 0.75 percent lending rate.