The blue and dark brown lines on the graph give an indication of this stability. To put it briefly, the paths in the chart can be construed as a sign that in 2024 to date, market agents have consistently expected a monetary easing phase to begin late in the year, whereupon interest rates would fall steadily during the ensuing term, even though they would be above pre-pandemic rates in the years ahead.

Volatility has been greater in the market for indexed Treasury bonds, which creates the basis for indexed interest rates in Iceland. As the chart shows, the spread between short-term and long-term indexed Treasury bond yields was relatively small about six months ago. The downward slope of the indexed real yield curve then started growing steadily steeper, peaking earlier this autumn. For instance, the three-year yield was 4.6% and the ten-year yield 2.6% about a month ago. It is worth noting that when the market is well balanced, it is normal that the yield curve should be upward-sloping, as investors want some remuneration for committing their capital for longer periods of time.

The increasing downward slope in the indexed yield curve was due to uncertainty about how the new motor vehicle taxation regime (which entails swapping out fuel taxes in favour of per-kilometre charges) would affect the CPI, as it was thought likely that the new set-up could beget a sizeable drop in the CPI at the turn of the year.

Statistics Iceland (SI) put paid to that speculation earlier this week, when it announced that the changes would not have that effect. While the ultimate impact has not yet been assessed, we think it will probably be modest. After SI issued its press release, the indexed yield curve flattened noticeably, although it still shows a distinct downward slope. Long-term real rates are therefore markedly lower than short-term real rates; for instance, the ten-year rate is now 2.6% and the three-year rate just over 4%.

What can we infer from this?

What does this downward-sloping yield curve mean in layman’s terms? To put it succinctly, it means that market participants expect the real interest rate in Iceland to decline steadily in the next few years. There are two main reasons for a lower real rate:

• All else being equal, slower economic growth and reduced demand pressures should lead to lower real rates, as there will be less demand for capital and the supply of savings will grow accordingly.
• Lower inflation will reduce the need for the CBI to maintain a tight monetary stance.

As regards the latter of these points, it is interesting to examine the relative pricing of indexed and nominal bonds. The difference between indexed and nominal bond rates, referred to in day-to-day speech as the breakeven inflation rate, largely reflects the market’s expectations about inflation in the coming term. Nevertheless, there are other forces at work as well, as is explained in an interesting new Working Paper by the CBI’s Chief Economist.

As the chart above indicates, the breakeven rate has been generally on the decline since the end of summer. Fluctuations in the two-year breakeven rate – which flipped from being far higher than the long-term rate to being somewhat below it and then shooting back up to a level close to the long-term rate – clearly reflect the above-described uncertainty about the short-run impact of the new motor vehicle tax scheme on the CPI, which was more or less swept aside earlier this week.

The breakeven inflation rate in the bond market is still uncomfortably high, and the CBI’s Monetary Policy Committee (MPC) has repeatedly voiced concerns about it in the context of recent interest rate decisions. As of this writing, the two- and five-year breakeven rate is 3.8%, while the ten-year rate is 3.9%. As is covered in the Working Paper mentioned above, the breakeven rate is not solely a reflection of inflation expectations, and its downward trend is a sign that the CBI’s monetary stance has begun to affect long-term as well as short-term market expectations. This is good news.

Expectations of lower interest rates

After just over a year at 9.25%, the CBI’s policy rate was lowered by 0.25 percentage points at the beginning of October. Price formation in the bond market suggests a general expectation that interest rates will keep falling in the quarters to come.

It therefore appears that the so-called implied forward Treasury bond rate is well in line with our preliminary policy rate forecast, issued right after the early October rate cut. This alignment is on the strong side for the next few quarters, at any rate. We expect the policy rate to fall below 7% by the end of 2025 and below 6% a year later. Based on the implied forward rate curve, however, the pace of monetary easing will slow down further ahead. On that front, though, it is important to remember that long-term interest rates generally include a premium to compensate investors for tying up their funds for longer periods of time.

To summarise, the Treasury yield curve in the market can be assumed to reflect the expectation that interest rates will decline overall, initially because nominal rates tend to chase falling inflation, while later on, real rates will fall as the economy rebalances and inflation moves within striking distance of the CBI’s inflation target. Even so, the outlook is for both nominal and real rates in Iceland to be noticeably higher, on average, than rates in neighbouring countries. In our opinion, this is due to a rather more ambiguous outlook for inflation and to a generally more favourable GDP growth outlook for Iceland than for many of its neighbours.