Foreign bond yields down sharply

Even though yields on Icelandic Treasury bonds have fallen, the long-term interest rate differential with abroad has grown in the recent term, as yields on comparable bonds issued in major currencies have fallen even more than yields on Icelandic bonds. For instance, the yield on ten-year US Treasury bonds has fallen by nearly a percentage point, while yields on comparable German and British bonds are down by 0.8 and 0.9 percentage points, respectively. 

The long-term interest rate differential between the ISK and its foreign counterparts, as reflected in government bond yields, has therefore widened significantly in recent months. The interest rate spread versus the euro is now 5.2%, its widest since before the pandemic, as the chart indicates. The spread is 3.3% against the US dollar and 3.5% against the pound sterling. These are the widest spreads versus the currencies in question since this past March.

Steep interest rate cuts widely expected abroad in 2024

But what is causing this abrupt reversal in long-term interest rates? To make a long story short, changed expectations about leading central banks’ policy interest rates have been a major factor. Last week, for example, the European Central Bank, the US Federal Reserve, and the Bank of England all announced unchanged policy rates. Market agents have interpreted statements from these banks’ officials as an indication that rate cuts in 2024 would come earlier and be larger than previously anticipated. Actually, central bankers and other monetary authorities in these economies have tried, in both spoken and written announcements, to dampen these hopes, but the market seems relatively impervious to caution in this regard.

According to the most recent summarised report from Reuters, foreign financial analysts expect policy rates to start falling this coming spring in the euro area and by late summer the UK and the US. Derivatives markets are actually pricing larger rate cuts into 2024 prices than forecasters are indicating. By this measure, Refinitiv expects a 1.5 percentage point rate reduction in the eurozone in 2024. A similar rate cut is expected in the US in the coming year, and for the UK, a rate cut of just over a percentage point is anticipated.

In comparison, our most recent policy rate forecast assumes that rates in Iceland will hold steady until Q2/2024 and then fall by a total of 1.25 percentage points by the year-end. The forward yield curve in the market indicates that expectations in the bond market are broadly in the same vein.

The real interest rate differential is smaller than its nominal counterpart

Although nominal interest rates show a large – and widening – spread between Iceland and its largest neighbouring countries, real interest rates give a more complex picture. Indexed bonds are less common in most foreign markets than they are in Iceland, but even so, the US, UK, and German governments all issue them.

As is the case with non-indexed rates, real yields on indexed bonds have fallen somewhat in recent weeks. Nevertheless, there is a vast difference between yields on indexed bonds issued by the US Treasury and those issued by the UK and Germany. The difference between the real yield on ten-year bonds issued in krónur (2.8%) by the Icelandic Treasury and TIPS bonds issued by the US Treasury (2.0%) is therefore less than 1 percentage point, while comparable bonds from the UK and Germany can be had for a yield of less than 0.5%. The real spread between Icelandic bonds and those from the latter group of countries is therefore around 2.5 percentage points.

This differential between bonds issued in the three currencies in question also reflects other factors, including expectations about GDP growth in the countries concerned. For instance, Reuters’ composite forecast suggests that analysts expect GDP growth in the US to measure 2.4% this year and 1.2% in 2024. For the UK, the same figures are 0.5% and 0.4%, respectively, and for the eurozone they are 0.5% and 0.6%. It is worth noting here that in our macroeconomic forecast from this autumn, we projected output growth in Iceland at 2.2% this year and 2.6% in 2024.

Divergent inflation expectations play their part

All of this begs the question: why is the differential between long-term nominal rates in Iceland and these three large economies so much larger than the spread between real rates? The answer is simple: differences in inflation expectations.

Based on the composite forecast from Reuters, our foreign counterparts expect year-2024 inflation to measure 2.6% in the US, 2.5% in the euro area, and 3.0% in the UK. For 2025, the same figures are 2.3% for the US and 2.1% for the other two regions. In Iceland, however, the Central Bank’s (CBI) most recent forecast assumes an inflation rate of 5.7% in 2024 and 3.6% in 2025, whereas our own most recent forecast is rather bleaker: we expect inflation to measure 6.3% in 2024 and 3.9% in 2025. The newly published survey of leading Icelandic executives’ inflation expectations tells a broadly similar tale.

As a result, it is well worth the effort to gain greater control of inflation and inflation expectations. Although real interest rates in Iceland are unlikely to align with those in the UK and mainland Europe, we consider it useful to look to the US for an interest rate level that could take hold once inflation has subsided and inflation expectations have rebalanced.