June 13 (Bloomberg) -- Iceland's stock market and currency are among the world's best performers this year after teetering on the brink of collapse in 2006. The island's record interest rates and relatively low equity prices will drive more gains.

``Stocks will rally another 10 to 15 percent,'' said Gudmundur Gudmundsson, head of trading at Kaupthing Bank hf in Reykjavik. ``The krona is still going strong and will retain its strength in 2007'' on expectations rates will stay near records.

The krona has risen 12 percent against the dollar this year, the second-largest advance globally after the Colombian peso. The ICEX 15 Index is up 26 percent, the biggest gain among Western European benchmarks. Shares of Kaupthing, Landsbanki Islands hf and Glitnir Bank hf, which account for two thirds of the ICEX 15's value, are surging.

There's more room for gains because the market is relatively cheap. Stocks in the ICEX 15 trade at 12.8 times estimated earnings, compared with 13.8 times profit for stocks in the pan-European Dow Jones Stoxx 600 Index. Investors will continue to be lured by interest rates that are the highest in Europe.

``The momentum in Icelandic equities is very strong,'' said Ulf Ingemarson, who helps oversee the equivalent of $440 million at Simplicity AB in Varberg, Sweden. ``We have increased our holdings this year.''

Banking Shares

Icelandic stocks are the fastest-growing group in his firm's investments. Simplicity AB owns shares of the three big banks and FLSmidth A/S, the world's largest builder of cement plants.

Shares of Kaupthing, the country's biggest bank, have risen 29 percent this year. Glitnir, the second largest, has gained 22 percent and Landsbanki, No. 3, has rallied 42 percent.

The stocks have gained as the companies raised funds and made acquisitions abroad, said Claes Ahrel, a Stockholm-based equity strategist at Laensfoersaekringar, which manages the equivalent of $20 billion, including Kaupthing stock.

Kaupthing raised its stake in Storebrand ASA, Norway's biggest publicly traded insurer, to 20 percent last month. Landsbanki agreed in May to buy Bridgewell Group Ltd., a U.K. investment bank, for 60.3 million pounds ($119 million). Glitnir bought Swedish brokerage Fischer Partners last year.

``All the Icelandic banks have been timing their acquisitions enormously well, snapping up banks at bargain prices,'' he said.

Rollercoaster Economy

The markets and economy of Iceland, an island of 300,000 people in the north Atlantic, have been riding a rollercoaster for the past three years. The economy surged in 2004 and 2005, expanding 7.6 percent and 7.2 percent, respectively, as the government and Alcoa Inc., the world's second-largest aluminum producer, spent billions of dollars to build a power plant and aluminum smelter.

The central bank, Sedlabanki, responded by pushing the benchmark interest rate to 10.75 percent in January 2006 to keep growth from overheating. The bank has since raised it to a record 14.25 percent. Speculators borrowed in countries such as Japan, where benchmark rates are 0.25 percent, to invest in Icelandic government bonds that yielded more than 9 percent. Those so-called carry trades pushed the krona higher.

Money began to flow out of the country in March 2006 when Japan raised interest rates, sparking concern the carry trade would become less profitable. And the rise in Icelandic rates threatened to throw Iceland's economy into recession.

The krona lost 17 percent against the dollar from Jan. 6 to April 20 last year. The ICEX 15 declined 24 percent from its peak on Feb. 15 last year, before bottoming out in July.

Growth Rates

Though the economy followed suit, it never fell into a recession. The growth rate slipped to a three-year low of 0.5 percent in last year's third quarter before rebounding. For the full year, the economy grew 2.6 percent.

First-quarter growth shrank 0.1 percent, the first contraction in three years, Iceland's statistics agency said today, after expanding 2.5 percent in the previous period. The economy will slow further this year, to 0.9 percent, before re- accelerating to 2.9 percent next year, the Finance Ministry forecast in April.

Tourism, Iceland's second-biggest source of foreign income after fish, is booming. The number of visitors to the country jumped 12 percent to 398,000 last year, the National Tourism Board said. More than 380,000 people went to the Blue Lagoon, the island's open-air pool heated by geothermal energy from the earth's interior.

The aluminum industry is boosting growth too. It accounted for 40 percent of Iceland's business investment last year, according to Glitnir. The construction of two smelters by Alcoa and Century Aluminum Co. amounts to between 6 percent and 7 percent of the $16 billion economy.

Economic Imbalances

Not everyone agrees the economy will continue to avoid recession.

``The imbalances in the economy remain unsolved, and have grown larger,'' said Lars Christensen, a senior strategist at Danske Bank A/S in Copenhagen. ``We still have a significant risk of a hard landing. The kind of turmoil we saw last year will reemerge. It's a good time to enter these markets only if you're willing to take risks.''

In 2006, the current-account gap was 26.5 percent of gross domestic product, up from 16 percent in 2005, the statistics agency said March 14. The current account is the broadest measure of international trade.

Inflation fell in May more slowly than the central bank expected, dropping to 4.7 percent from 5.3 percent in April. That will prevent the central bank from cutting interest rates until the fourth quarter at the earliest, Christensen said.

Yields Rise

The yield on Iceland's 7 percent note due March 2010 has leapt more than 3 percentage points, to 11 percent, since Fitch cut its outlook for the government's debt more than a year ago and the central bank raised its benchmark interest rate to 14.25 percent. Yields on German government notes of a similar maturity have climbed 1.46 percentage point in same period to 4.46 percent. U.K. bond yields have risen 1.5 percentage point to 5.75 percent.

Some investors say Icelandic yields provide enough reward to account for the risk.

``It's a good investment to buy fixed income in Iceland,'' said Ross Porter, a money manager at Stavanger Fondsforvaltning AS, which oversees $11 billion in Stavanger, Norway. ``Concerns about the current account last year were overdone, inflation is falling rapidly and will reach its target level within the year.''

To contact the reporter on this story: Jakob Lindstroem in Reykjavik through the Stockholm newsroom at jlindstroem@bloomberg.net

Last Updated: June 13, 2007 12:29 EDT