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What is the market telling us about the outlook for interest rates and inflation?

Bond market entities are pricing higher real rates and lower inflation into Treasury bonds than before, in what could be a sign of enhanced confidence in the Central Bank’s (CBI) monetary policy. The policy rate looks set to remain high in the coming term but start to ease in 2024.

The bond market has been mercurial in recent days and weeks. Nominal Treasury yields have fallen significantly since the beginning of March, while indexed yields have held broadly unchanged. As a result, the breakeven inflation rate in the market has fallen steeply in March to date, after having hit its highest in several years around the beginning of the month. But what does this tell us about the market’s take on the inflation and interest rate outlook?

Yields on nominal Treasury bonds spiked in the first two months of 2023, in line with the rise in inflation and the policy rate. As the chart shows, short-term Treasury yields had risen to approximately 8.3% and ten-year yields to roughly 7.0% by end-February, after having climbed by 1.4 and 0.8 percentage points, respectively, since the turn of the year.

But the latter half of March brought some big news. On 22 March, the CBI announced an unexpectedly large policy rate hike of 1.0 percentage points. Although the rate increase was hefty and the tone in the Monetary Policy Committee’s (MPC) statement fairly stern, the MPC was not as unequivocal about the need for further monetary tightening as it had been in February. Long Treasury bond yields fell somewhat after the March rate hike was announced – in fact, they had been easing downwards since the beginning of the month.

Then came the March CPI measurement, published by Statistics Iceland (SI) yesterday. Headline inflation fell below the 10% threshold again, to 9.8%, and was at the low end of official forecasts. This was welcome news to bond market participants, and long-term nominal Treasury bond yields tapered off once again. As of this writing, [nominal] Treasury yields are 7.7% for three-year bonds, 7.0% for five-year bonds, and 6.4% for ten-year bonds. Long-term yields are steadily approaching their early January values, although they remain considerably higher than they were a year ago.

Expectations about the real rate have risen …

At the same time, indexed Treasury bond yields have developed quite differently. Yields on these bonds have generally risen year-to-date – by anywhere between 0.2 and 0.6 percentage points. Bond market participants are therefore pricing the real rate for the next few years at 2.0-2.1%, as compared with 1.2-1.5% a year ago.

What can we infer from these shifts and from current bond market yields?

First of all, expectations about the real rate have generally risen in the recent term. In our opinion, this implies, among other things, the expectation that the CBI’s nominal policy rate will be somewhat above inflation in the long term. Indexed bond yields probably include a term premium as well, but it can be concluded that the market expects the real policy rate to range between 1.5% and 2.0% over the next decade or so.

… and inflation expectations have fallen

In the second place, this shift presumably reflects market agents’ opinion that the inflation outlook has brightened in recent weeks. The breakeven inflation rate in the market has fallen considerably from its end-February peak. The three-year breakeven rate is now 5.7%, after topping out at 6.8% a month ago, and the ten-year breakeven rate is now 4.4%, down from last month’s 4.9%.

The CBI has paid close attention to the implied five-year rate five years ahead, which is derived from the five- and ten-year breakeven rates. This 5y-5y rate has fluctuated less than the short-term breakeven rate but has nevertheless fallen from 4.1% to 3.7% in recent weeks.

Of course, these breakeven rates are still far above the CBI’s 2.5% inflation target, but it is important to take into account the uncertainty premium included in nominal bond yields, as real returns are not guaranteed as they are with indexed bonds. Adjusted for this, the spread between the long-term breakeven rate and the CBI’s inflation target is somewhat narrower, especially given that the uncertainty premium can be assumed to rise when the inflation and interest rate outlook are unusually ambiguous.

The market expects lower interest rates in the long run

In the third place, the nominal yield curve reflects to a large degree the market’s expectations about the policy rate in years to come. It can be said that when pricing long-term bonds, market agents try to estimate average developments in short-term interest rates and then add a premium to compensate investors for the risk associated with locking in interest rates during periods of uncertainty about interest rates and inflation.

It can be inferred from implied forward Treasury bond yields, which are based on bonds with varying maturities, that the market expects short-term interest rates to be higher in the next year than they are at present and then to fall, to somewhat below 6% in four to five years or so.

We are somewhat more optimistic than the market about long-term policy rate movements. Based on the interest rate forecast included in our macroeconomic forecast from early February and developments since then, we expect the policy rate to average just under 8% in the next year, after one more rate hike this May. We then expect the CBI to start lowering the policy rate early in 2024, to perhaps below 5% in roughly two years’ time.

The MPC must certainly welcome this shift in the bond market, as it implies growing market confidence in monetary policy. But we aren’t out of the woods yet, as the CBI will presumably need to maintain a tight monetary stance in the coming term so as to preserve this favourable turn of events.


Jón Bjarki Bentsson

Chief economist