In a move that will send shivers through the bond markets and spike the risk premium on Israeli assets, Prime Minister Benjamin Netanyahu has ordered the Israeli Defence Forces to extend their operational hold over Gaza to 70%. This is not a territorial claim; it is a strategic clampdown. For investors, this is a classic case of escalating geopolitical risk that cannot be hedged with a simple currency swap.
The market reaction was immediate. The shekel fell 1.2% against the dollar in early trading, while the Tel Aviv Stock Exchange’s benchmark TA-35 index shed 0.8%. Investors are pricing in a prolonged conflict, one that could drain the fiscal coffers and force the Bank of Israel to rethink its hawkish stance. The central bank had been holding rates steady at 4.75% to contain inflation, but a war economy changes the calculus. Government spending will inevitably rise, and the deficit will widen. That means more gilt issuance, higher yields, and a potential crowding out of private investment.
Let’s look at the numbers. Israel’s debt-to-GDP ratio stood at 60% before the conflict. A sustained military operation could push that towards 70%, triggering credit rating agencies to sharpen their pencils. Moody’s has already placed Israel’s A1 rating on review for downgrade. A single notch downgrade could add 20 basis points to sovereign borrowing costs. For a country that relies on international capital markets to finance its deficit, that is not trivial.
But the bigger picture is capital flight. When a nation expands a conflict, foreign investors get twitchy. Portfolio flows, which had been positive in the first half of the year, could reverse. We have seen this script before: heightened geopolitical risk leads to a sell-off in local bonds and equities, a weaker currency, and ultimately higher inflation as import prices rise. The Bank of Israel may have to intervene, burning through foreign exchange reserves to defend the shekel. Those reserves stood at $200 billion as of June, but they can evaporate quickly when fear takes hold.
Netanyahu’s decision is a gamble. He is betting that a tighter grip will deliver a quicker resolution, thereby limiting the economic damage. But history suggests otherwise. Military escalations in asymmetric conflicts tend to be open-ended. The cost in blood and treasure can escalate faster than the Treasury can print bonds. The human cost is incalculable, but the financial cost is measured in basis points and yield spreads.
For global markets, this is a reminder that the Middle East risk premium is alive and well. Oil prices, already elevated due to OPEC+ cuts, could spike further if the conflict widens. Brent crude was hovering around $95 a barrel; a sustained ground offensive could push it past $100. That would feed into headline inflation across the developed world, complicating the Federal Reserve’s tightening cycle. The last thing the global economy needs is another supply shock.
Back in London, the FTSE 100 felt the tremors. Defence stocks rallied, with BAE Systems up 3%, but financials took a hit. Barclays and HSBC, heavily exposed to emerging markets, saw their shares dip. The gilt market, however, remained relatively calm. The 10-year yield held steady at 4.30%, as investors focused on domestic inflation data. But make no mistake, if the conflict escalates further, it will spill over into UK markets through higher energy prices and risk aversion.
Fiscal responsibility is the first casualty of war. Netanyahu’s government will need to fund this operation, and that means more borrowing. The Israeli Finance Ministry has already announced a $5 billion war bond issuance. That will soak up liquidity and put upward pressure on yields. For domestic banks, holding more government debt on their balance sheets increases their risk profile. The Bank of Israel may need to provide liquidity support, blurring the line between monetary and fiscal policy.
In the end, this is a bottom-line story. The bottom line for Israel is a higher risk premium, a weaker currency, and a wider fiscal deficit. The bottom line for global markets is another source of uncertainty in a world already grappling with inflation and tight monetary policy. Netanyahu has tightened the screws, but he may find that the economic costs tighten around his own government’s neck.
