In 2026 to date, there has been a general increase in nominal Government bond yields, which form the basis for bond market pricing overall. For example, the yield on Government bonds with a fixed 10-year duration has risen by about half a percentage point year-to-date, to nearly 7% as of this writing. Yields on bonds of shorter duration have risen even more. The three-year yield, for instance, is up 0.7 percentage points since the turn of the year, from 6.9% to 7.6%.

Interestingly, long-term rates as reflected in Government bond yields (indicated in dark grey on the chart) are higher now than they were in May 2025 (in light grey). At the end of 2025, the reverse was true, as can be seen in a comparison of the light grey path and the yellow one in the chart above.

This increase is due primarily to the expectation that short-term interest rates will be higher in the coming term than previously anticipated, as a calculation of implied forward rates shows clearly. With some simplification, these rates can be interpreted as an indication of where interest rates for a specified duration will lie after a given period of time. For example, the calculated implied five-year rate five years ahead, based on this theory and the most recent data, can be said to indicate what the market thinks the yield on five-year Government bonds will be at the start of May 2031.

As the chart shows, the aforementioned implied forward rates have been fairly stable in recent quarters. They climbed in early 2025, then dipped in the autumn when prospects for exports and disinflation dimmed, and currently stand at 6.5%. This is virtually the same as a year ago, but 0.2% higher than at the beginning of 2026.

In other words: The rise in the nominal Government yield curve is due almost entirely to expectations of higher interest rates over the next five years or so, and especially over roughly the next two years.

Long-term real rates have risen since last autumn

Naturally, nominal interest rates are not the final determinant of returns on savings or the real cost of borrowing. This is where real rates come in. Iceland has an unusually active market for inflation-indexed interest rates despite its small size, as most debt obligations undertaken by public entities, companies, and individuals are index-linked.

Real interest rates started rising steadily in Iceland in early 2025. Long-term real rates in terms of indexed Government bond yields peaked last autumn. Real rates have settled down a bit since then, although the decline has partially reversed in the wake of the Central Bank’s (CBI) 18 March policy rate hike.

As the chart indicates, long-term real interest rates in terms of the indexed Government yield curve are about the same as they were a year ago, while short-term real rates are still somewhat lower than in early May 2025. By this measure, the real interest rate stance is roughly the same as it was just before the CBI’s policy rate cut a scant year ago.

Breakeven rate on the rise

What do developments in these two types of Government bonds say about market agents’ inflation expectations?

As could be expected, when non-indexed base rates in the market rise at a time when real interest rates are broadly unchanged, the breakeven rate – i.e., premium that bond market participants consider necessary to put nominal long-term bonds and comparable indexed bonds on an equal footing – has risen. This is particularly the case with the breakeven rate over the few years just ahead.

As the chart shows, the breakeven rate in the market has risen quite a bit in 2026 to date, and the shorter the duration, the larger the increase. For example, our calculations indicate that the three-year breakeven inflation rate is about 4.6%, 0.8 percentage points higher than at the turn of the year. The ten-year rate, on the other hand, is now 4.1% and has risen by just under 0.4 percentage points over the same period. This lines up well with recent surveys of household and corporate inflation expectations, which show an increase of 0.3-1.0% in expectations over horizons of one, two, and five years.

If any positive conclusion is to be drawn from this shift in the breakeven rate, it is best to view implied long-term inflation expectations in the same way as the implied long-term interest rates discussed above. The calculated five-year breakeven inflation rate five years ahead (the breakeven rate for the period 2031-2035) has been quite stable in the recent term. According to our calculations, this breakeven rate is now 3.7%, about the same as at the start of the year but 0.2 percentage points lower than it was a year ago. It should also be borne in mind that the breakeven inflation rate in the market is not only a measure of inflation expectations; it also includes a premium for uncertainty about real returns or differences in the liquidity of nominal versus indexed bonds.

Increased likelihood of a policy rate hike on 20 May

In any event, developments in the short-term breakeven rate, as well as in inflation expectations and inflation itself, give cause for real concern. About ten days from now, the CBI’s Monetary Policy Committee (MPC) will meet and take a decision on the policy interest rate, to be announced on Wednesday 20 May. Back in March, the MPC was deeply concerned about developments in inflation expectations and the breakeven rate, and it was of the opinion that the 0.25 percentage point rate hike implemented at that time would only offset a part of the increased monetary slack associated with the aforementioned rise in inflation expectations. In view of developments since then, it is hard to imagine that the Committee will have any other option than to raise interest rates again on 20 May.