"We see increased uncertainty about the economic outlook in the coming months and risks becoming skewed to our adverse scenario," Morgan Stanley's analysts said in a research note.
"Markets are now likely to extrapolate the future policy path and we move Israel sovereign credit to a 'dislike stance'."
They added that recent developments pointed to "continued uncertainty" in Israel and for the shekel currency to weaken and borrowing costs to rise as investors attach a higher risk premium.
The crisis has caused a deep divide in Israeli society and sparked months of mass protests which have seen the shekel fall to a near 3-year low and the stock market lose nearly 10% since November.
"In our adverse scenario we think that growth could weaken significantly to 1.6% (year-on-year) in 2024 with inflation remaining significantly above the Bank of Israel's tolerance band."
"For now, we keep our call for one more 25 basis point hike to 5% at the BoI's September meeting, but risks to the rates outlook are now shifting to the upside again."
(Reporting by Marc Jones and Steve Sheer in Jerusalem, additional reporting by Ari Rabinovitch; Editing by Amanda Cooper)
By Marc Jones
