(Bloomberg) -- Israel was downgraded by S&P Global Ratings, which joined Moody’s Investors Service in lowering the nation’s sovereign credit score as geopolitical risks in the Middle East escalated.

S&P cut the rating by one notch to A+, the fifth highest level and on par with Bermuda and China. The outlook remains negative, and the rating will be reviewed again on May 10, S&P said in a statement.

The decision came hours before what two US officials said was a retaliatory strike by Israel on Iran. It followed less than a week after Tehran unleashed a rocket and drone barrage against Israel, raising fears of a widening conflict across the region. 

“The recent increase in confrontation with Iran heightens already elevated geopolitical risks for Israel,” S&P said. A wider regional conflict will likely be avoided, but the Israel-Hamas war appears set to continue throughout 2024, versus a previous assumption that military activity wouldn’t last more than six months, it said.

All three major rating firms have put out warnings on Israel’s credit score since the onset of the war with Hamas in October, which is draining the nation’s coffers. Moody’s gave the nation its first-ever sovereign rating downgrade in February, assigning it the sixth-highest investment-grade score. 

In the first official response to the announcement, the Finance Ministry’s accountant general, Yali Rothenberg, said Israeli government bonds remain “a safe and liquid asset” despite the risks outlined by S&P,  while the domestic economy is “diverse, innovative and fundamentally strong.”

Still, Rothenberg, who’s in charge of managing Israel’s debt stock, called for caution in the government’s handling of the budget.

“We must act with fiscal responsibility in order to ensure long-term growth of the economy and decrease the debt-to-GDP ratio,” he said. “Israel will successfully face all challenges it faces.”

The rating downgrade may add pressure on Israel’s bonds and the shekel, which has fallen over 4% this year against the dollar. The cost of hedging against losses in the shekel has jumped as traders brace for a possible escalation of the conflict, undaunted by the central bank’s resolve to defend the currency. 

“Now that geopolitical relations have broadened and worsened, and the war budget likely to be in place for an extended period of time, the one-notch downgrade and retaining the negative outlook is more than justified,” said Brendan McKenna, an emerging-markets economist and currency strategist at Wells Fargo & Co. in New York. 

Israel’s 10-year bond yields are likely to rise toward 5% and the shekel will face pressure on the back of the downgrade, he said.

S&P forecast that Israel’s general government deficit will widen to 8% of gross domestic product in 2024 — higher than the government’s estimate of 6.6% — mostly due to higher defense spending. Bigger shortfalls are likely to persist over the medium term and net general government debt is set to peak at 66% of GDP in 2026, the ratings firm said.

Israel’s balance of payments remains a key strength, driven by decades of current-account surpluses, S&P said. Under the assumption that the war against Hamas continues throughout 2024 but doesn’t lead to a wider regional conflict, the rating company predicts Israel’s economic growth at just 0.5% this year, according to the rating company.

“Recent months mark the first time in two decades when geopolitical risks are factored into the pricing of Israel’s debt,” said Yaniv Pagot, head of trading at at the Tel Aviv Stock Exchange. “The expansion of the military conflict or additional economic damages may result in a further downgrade within a period of 12-24 months.”

(Updates with comments starting in sixth paragraph. A previous version of the story was corrected to remove reference to this being the first-ever downgrade.)

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