The Bank of England and the European Central Bank also held rates unchanged at their last rate-setting meetings, although they conveyed a milder tone in their statements and signalled that rate cuts are in the offing. Furthermore, international money markets have priced in sizeable rate cuts this year.

In a noteworthy development, the Swiss National Bank led the way with a rate cut on 21 March, and later that day Norges Bank and the Bank of England announced unchanged policy rates. These shifts in the global interest environment could bring about changes in financial conditions in Iceland if inflows into Icelandic Treasury bonds continue.

Foreign investors are gaining ground but account for a historically small share

According to the Central Bank’s (CBI) Financial Stability report, non-resident investors owned Icelandic Treasury bonds worth ISK 86bn at the end of February, or around 7% of the outstanding ISK-denominated Treasury bond stock. The report also notes that this share is low in historical context, as non-residents held about 13% of outstanding Treasury bonds shortly before the pandemic. In our opinion, the outlook is for foreign investors’ share to increase in the near future, particularly if interest rate cuts abroad are more rapid than in Iceland and begin sooner, as is currently expected.

The first signs of inflows into Treasury bonds are seen in the foreign exchange market, as the ISK appreciates strongly when inflows surge. This happened in connection with the February auctions of RIKB 26 and RIKB 35, when non-residents bought bonds for nearly ISK 15bn. A substantial appreciation of the ISK can adversely affect the competitiveness of the export sector, but it can also ease inflationary pressures by lowering the price of imports and reducing domestic demand pressures. If the CBI is not on board with the appreciation accompanying such purchases, it buys currency in the market. This was the case in February, when the CBI bought foreign currency for ISK 9bn in the interbank market on the bond auction date. The risk associated with the inflows is that Iceland’s external debt will rise and the share of bond payments exported from Iceland increases as foreign ownership will grow. This is not cause for particular concern at present, however, as Iceland’s net external position has been increasingly positive, and domestic investors, especially the pension funds, have been steadily adding to their foreign securities holdings.

When will interest rate cuts start?

Opinion is divided on when interest rate cuts will begin and how fast rates will fall, both in Iceland and elsewhere. Some market participants have posited that policy rates will be kept higher for a longer period of time. This could mean that the wait for monetary easing could be longer than many had hoped, and that the easing phase will be more drawn out. Nevertheless, most indicators imply that interest rates in the world’s largest economies have peaked and that their central banks are preparing to start rate cuts.

It is quite likely that the interest rate differential with abroad will widen in tandem with rate cuts abroad, even if Iceland’s monetary easing phase begins soon. This could stimulate further inflows into Treasury bonds and perhaps other debt instruments as well, echoing the strong capital flows into private credit markets abroad.

In our opinion, there are a number of factors suggesting that a policy rate cut is imminent in Iceland, despite the neutral forward guidance provided by the Monetary Policy Committee (MPC) at the last interest rate announcement. Several economic indicators support this hypothesis: new motor vehicle purchases have tumbled relative to 2023, the labour market is cooling, and the economy seems to be heading for a relatively swift landing. All of this is offset by the Government buy-up of homes in the town of Grindavík and the associated upward pressure on house prices, which could cause inflation to fall more slowly than previously forecast. Moreover, the newly signed wage agreements have had a positive impact on inflation expectations, but contracts are still outstanding for a large share of the labour market, and the results of agreements made with this latter group will probably affect inflation expectations in the near future. The recent wage agreements were also accompanied by a hefty Government spending package, and it is still unclear how that spending will be financed.

Developments in long-term interest rates in Iceland have somewhat resembled those in the US, where inflation has been more persistent than market agents anticipated. In spite of this, the US Federal Reserve has signalled strongly that it will probably start lowering the policy rate this year, whereas the CBI has not implied anything of the sort.

Market for forward contracts

In some instances, foreign investors use forward contracts to hedge against exchange rate risk when they buy Icelandic securities. If inflows into Treasury bonds increase, the market for forward contracts involving the ISK will probably liven up as well. This should deepen the market, bolster liquidity and efficacy, and improve price formation. Furthermore, as with forward FX contracts, shifts in the global interest rate environment would act as a catalyst for interest rate swaps, livening up that market. Interest rate swap agreements based on payment flows in various currencies against the ISK would probably increase as well. This would be offset by the CBI’s intervention in the FX market, which would mitigate exchange rate volatility and thereby diminish the need for exchange rate hedging, as reduced volatility could lower the price of such hedging instruments.

Recent developments in the bond market

The Housing and Construction Authority (HMS) recently issued a new quality-adjusted Real Estate Price Index showing a month-on-month increase of just under 2% in February. The issue appears to have boosted bond yields across the yield curve and pushed the breakeven inflation rate higher. As we see it, the MPC’s interest rate decision of 20 March and the tone in its statement from that day had a similar upward impact on bond yields and the breakeven rate. By the same token, disappointing inflation figures for March put upward pressure on both bond yields and the breakeven rate.

The overall situation

Because the pension funds purchase large amounts of foreign securities, inflows into Icelandic securities should be accompanied by a better balanced current account, as has apparently been the pattern in recent quarters. Non-resident investors’ participation in the Icelandic securities market leads to a more diversified owner group. A more diverse investor base with dissimilar objectives and opinions is likely to promote active exchange of opinion and could dampen price volatility. The pension funds’ overseas investments and non-residents’ investments in Iceland help diversify risk for both parties and are of benefit to the domestic economy. The purpose for which securities investments are undertaken affects macroeconomic risk and the associated benefits.

If the bonds are bought with an eye to holding them to maturity, there is little balance of payments risk involved. If they are bought as a means of betting on interest rate cuts, however, outflows from the sale of the bonds could be less predictable and swifter and more sudden than in the long-term scenario. That said, non-residents’ investments are not yet large enough to occasion significant concern, particularly against the backdrop of the CBI’s ample international reserves and Iceland’s strong international investment position.