Over the course of the autumn, however, long-term Government bond yields started to fall more steeply. From end-September until 19 November, the CBI’s last policy rate decision date of the year, the 10-year benchmark yield fell by 0.4 percentage points, and since 19 November it has eased by a further 0.1 percentage points. This decline in yields is due in part to a surge in foreign investors’ interest in the bonds early in the autumn. These investors have variously bought and sold Icelandic Government securities in the past year, and as of end-November their total Government bond holdings were more or less unchanged year-to-date.

Two main reasons for the drop in long-term yields

Ultimately, there are two factors that probably weigh heaviest in the past few months’ decline in long-term yields: the prospect of lower real rates due to a worsening economic outlook and a change in market agents’ estimate of the breakeven inflation rate, which compensates investors for expected inflation and uncertainty about the inflation outlook.

In order to estimate the weight of these two factors, it is useful to look also at developments in indexed long-term rates as they are reflected in the yield on 10-year inflation-indexed Government bonds. Like the nominal yield, the yield on indexed long-term Government bonds rose markedly in early 2025. That increase came a bit later, however, emerging for the most part in the summer, when the 10-year indexed yield rose from 2.7% at the start of May to 3.1% by late summer.

The summer spike reversed in full – and then some – between early September and the end of November, but the yield has inched upwards again since and is currently around 2.75%.

The breakeven inflation rate has tapered off

In comparing developments in nominal and indexed bonds, it is possible to calculate the 10-year breakeven inflation rate. The CBI’s Monetary Policy Committee (MPC) considers the long-term breakeven rate in the bond market in its assessment of inflation expectations in the domestic economy.

As the chart indicates, the long-term breakeven rate clung stubbornly to its perch just below 4% for most of this year, apart from some short-term fluctuations. In Q4, however, it has fallen somewhat, particularly during the period since mid-November. At present it is 3.7%, according to our calculations, down from 3.9% just a month ago. It should be borne in mind that the breakeven rate reflects not only market agents’ inflation expectations, but also a premium to compensate for uncertainty about inflation and the relative liquidity premium on various types of Government securities. A 3.7% long-term breakeven inflation rate is nevertheless uncomfortably high, even though the decline is welcome.

To put it succinctly, the 0.5 percentage point drop in long-term rates since early October can be broken down as follows:

• approximately 0.25 percentage points due to a lower real rate; i.e., a decline in inflation-indexed long-term base rates;
• approximately 0.25 percentage points due to a lower inflation breakeven rate in the market.

In other words, changed expectations about real rates and a lower breakeven inflation rate contribute equally to the Q4 decline in long-tern nominal rates.

The long-term interest rate differential has narrowed

Despite declining somewhat in H2/2025, long-t5erm interest rates in Iceland are still high in international context. Nevertheless, it is intriguing to compare developments in Iceland with those in key trading partner regions. In many foreign markets, base interest rates have either been climbing or have held broadly steady at a time when policy rates have either fallen or remained flat. Among other things, this reflects concerns about excessive debt accumulation and unsustainable public finances among some of the world’s largest countries, but it also indicates expectations of more persistent inflation and rising term premia due to growing uncertainty.

For example, the yield on 10-year US Treasury bonds has fallen by only 0.1 percentage points since mid-year, and the yield on comparable British government bonds has held unchanged. At the same time, the yield on German government bonds, which reflects base rates in the eurozone, has risen by nearly 0.3 percentage points, and in Japan, 10-year base rates have risen nearly 0.6 percentage points. Over this same period, policy interest rates have been lowered by 0.75 percentage points in the US and by 0.25 percentage points in the UK. In the eurozone, interest rates have been unchanged since mid-June, and in Japan they have been unchanged since January. In Japan, inflation has finally returned, after a decades-long hibernation interspersed with periods of deflation.

These developments have caused the long-term interest rate differential between Iceland and key currency areas to narrow in H2/2025. This also applies to the US, although the policy rate there has been lowered far more than it has in Iceland. For example, the spread between 10-year base rates in Icelandic krónur and euros has shrunk from 4.4% to 3.5% during the period. The comparable spread versus the US dollar has contracted from 2.7% to 2.2%, and the spread versus the pound sterling has shrunk from 2.5% to 1.8%.

Long-term interest rates likely to fall further

The outlook is for further cuts in Iceland’s policy rate in 2026. How much the policy rate is lowered will depend largely on the degree to which headwinds in key export sectors impede growth in the economy as a whole, and the degree to which an improved inflation outlook and lower inflation expectations reduce the need for monetary restraint. By the same token, the breakeven inflation rate in the market could fall, driven partly by the cooling economy, slower rises in house prices and rent, and a bigger slack in the labour market. As a result, long-term rates will probably continue to ease in the coming term, even though lower real rates and a lower breakeven rate have already been priced into them.