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Interest rate cuts bring end to long Icelandic krona rally

While a strengthening global economy is encouraging central bankers across the developed world to finally look at raising interest rates, on the outskirts of Europe one bank is seeing some success by moving in the opposite direction.

Iceland’s krona hit an 11-month low against the euro on Wednesday, as a series of rate cuts appear to have finally brought an end to a long rally that was making it impossible to meet the central bank’s inflation target.

The nordic island rejoined global financial markets in March, lifting capital controls that were put in place to stabilise the krona when its banking sector collapsed in 2008.

The move – which allowed domestic pension funds to diversify their assets and invest abroad – briefly dented the krona’s long run, but the rally quickly restarted. The currency strengthened more than 15 per cent last year and a further 6.7 per cent in the first six months of 2017.

However, a slower than expected start to the year reduced fears that a rate cut could encourage the economy to overheat, allowing the Sedlabanki to begin bringing down its key rate – which at 5 per cent offered a very attractive yield when much of Europe still has negative rates. The krona has since reversed all of this year’s gains, falling 11.5 per cent since the first cut was announced in May.

Capital Economics analyst Stephen Brown says the krona’s reversal makes the Sedlabanki unlikely to cut again at its policy meeting next week, when the bank could raise its inflation forecast for next year from 2.3 per cent to as much as 4 per cent.

But that doesn’t mean the cycle – or the chance of further dramatic currency swings – is over: Mr Brown points out that inflation excluding housing costs is still mired in negative territory, and said “we expect the krona to rise again before long due to Iceland’s strong fundamentals, and given committee members’ concerns about low underlying deflation, we suspect that interest rates will eventually be cut further”.

Photo: Getty