However, the impact of less favourable external trade did not show in the ISK exchange rate until this summer, as is noted above. There are two main explanations for at least a fair share of this trend:

• First of all, there was significant position-taking with the ISK early in the year, followed by a reversal in late summer. This is discussed in the Central Bank’s (CBI) newly published Financial Stability report. In that report, the CBI notes that the commercial banks’ net forward FX position declined by ISK 30bn in July and August. In H1, however, the position had increased by about the same amount. The banks’ net FX position at any given time reflects their customers’ position-taking with the ISK, either for hedging or for speculative purposes. The impact on the FX market actually comes to the fore when the contracts are made rather than when they mature.

• Non-residents’ net new investments in domestic financial assets were sizeable in Q1, but negligible thereafter. According to CBI data, they totalled ISK 26bn through end-March, then fluctuated slightly in the months to follow, until August, when inflows came to just over ISK 3bn. The bulk of Q1 inflows were due to Treasury bond purchases, while inflows in August were used mainly for stock purchases. Although the CBI bought some of the FX imported in February (for a total of just over ISK 9bn) and added that amount to the international reserves, the remaining ISK 17bn financed the current account deficit for the period, directly or indirectly.

In the past few weeks, the ISK has appreciated once again. For example, a euro now costs ISK 150.4 in the interbank market, down from its recent peak of ISK 153.4 at the beginning of September. By this measure, the ISK has strengthened by nearly 2%. Against the US dollar, the ISK has appreciated by nearly 3% over the same period, as the dollar has slid against other currencies.

Official figures do not provide an explanation for this ISK appreciation, but there are several possibilities:

• The interest rate differential with abroad is still wide, and the late-summer ISK depreciation may have piqued foreign funds’ interest in investing in domestic securities, as in Q1/2024.
• According to the CBI’s Financial Stability report, the pension funds have scaled down their FX purchases this year. Over the first eight months of 2024, their net purchases totalled 51 b.kr., or 17 b.kr. less than during the same period in 2023. Nevertheless, the share of foreign assets in their portfolios has generally continued rising, owing to tailwinds in foreign markets. The CBI points out that at mid-year, 18 of Iceland’s 21 pension funds were close to or above the targeted ratio of foreign assets provided for in their internal investment strategies.
• September appears to have been a decent month for tourism; therefore, tourism-generated inflows at the end of the peak season may well have been fairly large. If commercial bank customers’ forward positions with the ISK have not shrunk still further, such inflows may have supported the exchange rate since the beginning of September.
• It looks as though a conclusion will be reached in the next few months on JBT’s takeover bid for Marel. Marel is owned mainly by domestic investors, pension funds in particular, and the deal would provide them with a combination of cash in euros and shares in the merged company. These parties’ interest in FX purchases could therefore plunge briefly, and it is possible that some domestic parties will ultimately reinvest some of the proceeds in Iceland.

As a result, the ISK could perk up further over the remainder of the year, although naturally, factors such as external trade and forward position-taking in the FX market will carry significant weight as well.

Gentle tailwinds to support the ISK over the next two years

In our newly published macroeconomic forecast, we review the outlook for the ISK in the coming term. Near-term prospects for external trade are slightly poorer than in our last forecast. The outlook is for a current account deficit this year and a balanced current account in 2025 and 2026. In May, though, we projected a modest surplus in 2024 as well as the two years afterwards.

Even so, several factors should be rather positive for the ISK. The outlook is for a sizeable interest rate differential with abroad in the coming term. Furthermore, Iceland’s external position is still strong, and the stock of foreign-owned securities is modest in historical and international context.

Offsetting potential FX inflows from the above-mentioned sources are factors such as the pension funds’ continued foreign investments. Other domestic entities could also step up foreign investment in the future, particularly if the ISK strengthens more than we expect.

As is typically the case, short-term ISK volatility can be expected. In our view, though, the big picture is that the ISK will probably hold rather stable, with the possibility of a slight appreciation as the current account balance improves. Our forecast assumes that the ISK will be roughly 2% stronger at the end of the forecast horizon than it was in August 2024. This translates to a price of ISK 148 per euro, which is slightly weaker than in our previous forecast.

Although the nominal exchange rate will increase only slightly in our forecast, rapid wage growth and higher inflation than in trading partner countries will cause the real exchange rate to rise, although it will probably not reach its previous high. Iceland’s competitive position should therefore remain slightly more favourable than in 2017-2018 and during the 2005-2007 boom. In all likelihood, though, the real exchange rate will ultimately rebalance as it has done before, with a nominal depreciation of the ISK, if the differential between domestic and foreign inflation and wages persists.