In many of the world’s major economies, interest rates have risen markedly in the recent past, causing tremors in financial markets. For instance, the yield on 10-year US Treasury bonds has risen by over a percentage point since the beginning of October 2024. As of this writing, the 10-yr Treasury yield, one of the chief benchmarks for long-term US dollar rates, was 4.8%. A similar trend has been seen in the UK, where the 10-year yield has risen by just over 0.9 percentage points, to 4.9%, and in the eurozone, where the yield on 10-yr German government bonds is up by 0.6%, to 2.6%. To put this into context, the yield on comparable Icelandic Treasury bonds has risen by 0.1 percentage points, to 6.6%.
Interest rate differential narrows as winter advances
Rising long-term interest rates in most currency areas have tended to narrow Iceland’s interest rate differential with abroad in recent months. A smaller differential concurrent with the appreciation of the ISK is likely to dampen foreign investors’ interest in buying króna-denominated Treasury bonds. The Central Bank (CBI) Monetary Policy Committee (MPC) will probably take note of the shrinking differential when it meets next, but presumably there is still room to lower the policy rate in coming months.
There are various explanations for this, but a recent article in The Economist gives a rundown of several key points:
- The short-term inflation outlook has deteriorated. Although inflation has tumbled from its recent global peak, price pressures remain. In leading advanced economies, wages are growing in excess of the largest central banks’ 2% inflation targets, and the pace of inflation picked up in many countries towards the end of 2024. Expectations of sizeable policy rate cuts have dimmed as a result, particularly in the US, where a single 25-bp rate cut is all that is expected in 2025.
- Term premia have risen, probably because of elevated economic uncertainty, with factors such as the prospect of tariff disputes, widespread war, and the impact of deglobalisation will offset possible tax cuts in the US and an AI-induced jump in productivity.
- Fiscal policy is far from tight in most advanced economies. The Economist notes that the G7 countries will probably run an average budget deficit of 6% of GDP in 2025. Such hefty deficits have generally been associated with strong economic headwinds, but these days output growth is acceptable and most labour markets quite strong. Accommodative fiscal policy goes hand-in-hand with issuance of bonds to cover deficits at a time when leading central banks are considering selling off some of the massive stockpile of bonds they bought during the pandemic as part of their quantitative easing policies in a bid to push long-term interest rates downwards.
This surge in foreign bond yields alongside largely unchanged long-term base rates in Iceland has squeezed Iceland’s long- and short-term interest rate differential with abroad in the recent past. For instance, the spread between Icelandic and US two-year Treasury bonds has narrowed by 1.3 percentage points, the spread against two-year bonds issued by the UK is down 1.5 percentage points, and the spread against German bonds has shrunk 0.9 percentage points since the beginning of October.
The same pattern can be seen in the case of long-term yields. Since early October, the spread between Icelandic 10-year bonds and comparable foreign issues has narrowed by just under 1 percentage point versus the US dollar, 0.9 points versus the pound sterling, and 0.4 points against the euro. The 10-year differential is now about 2.2% against the US dollar, 2.1% against the pound sterling, and 4.3% against German-issued eurobonds.
These narrower spreads are likely to affect foreign investors’ appetite for Icelandic Treasury bonds. We reported recently about the increase in non-residents’ Treasury bond holdings in autumn 2024, which probably contributed to the appreciation of the ISK in the final four months of the year. The two numbers non-resident investors are likely to heed most closely are the spot ISK exchange rate and the spread between their home currency and the ISK. If they think the ISK is likelier to strengthen than weaken at a time when Icelandic interest rates are considerably higher than rates in their home countries, these investors will be far readier to buy Icelandic Treasury bonds.
According to Government Debt Management’s most recent issue of Market Information, non-residents had beefed up their Icelandic Treasury bond holdings by a full ISK 38bn in 2024, to just over ISK 104bn by the year-end. In all, then, foreign investors held just over 11% of the outstanding Treasury bond stock at that time. Even so, this is a modest share in global context; for instance, foreign investors hold anywhere from 35% to 60% of government bonds issued in the other Nordic countries’ domestic currencies
The long-term real spread versus the US is small
It is also interesting to examine differences in long-term real rates as they are reflected in various countries’ bond markets. Although price indexation is uncommon in most foreign credit markets as regards bonds issued to individuals and small businesses, many large countries issue indexed government bonds that can be compared to indexed Icelandic Treasury bonds. Unlike in the above-mentioned currency areas, the indexed yield curve in Iceland is steeply downward-sloping, with far higher yields on short-term indexed Treasury bonds than on the longest issues.
This difference is particularly striking in a comparison between real Treasury bond yield curves in Iceland and the US. As the chart shows, the five-year differential is fairly wide, at about 1.1 percentage points, while the 10-year spread is only about 0.1 percentage points, which gives US investors little incentive to buy indexed Icelandic bonds instead of their own government’s Treasury Inflation-Protected Series (TIPS) issues.
The small differential between indexed and non-indexed long-term yields in ISK and USD reflects the far higher breakeven inflation rate in the Icelandic bond market than in the US market The 10-year breakeven rate based on Icelandic Treasury yield curves is just under 4% at present, while the comparable breakeven rate in the US is 2.5%. In the eurozone, the 10-year breakeven inflation rate is very close to 2.0%. It is worth remembering that the Central Bank of Iceland’s inflation target is 2.5%, while the US and most other large economies have an inflation target of 2.0%.
Of course, the breakeven rate is not a pure measure of inflation expectations, as it also reflects factors such as liquidity and the indirect premium that investors are willing to pay in order to ensure a given real return. Nevertheless, we consider it clear from this comparison that anchoring long-term inflation expectations will be harder for the CBI than for its counterparts in the above-mentioned economies – and most other industrialised countries, for that matter.
Policy rate cut likely despite smaller interest rate differential
The shrinking interest rate spread will probably be an argument against a large policy rate cut when the MPC meets on 5 February. Even so, it is worth noting that Iceland’s real rate is high and has not fallen to any significant degree in recent months, even though the nominal policy rate was lowered in Q4. As a result, we think there is still scope for the MPC to lower the policy rate at its upcoming meetings.
