The Bank of England has raised borrowing costs in the last 18 months, which have led to a rise in UK mortgage rates. The latest spike, which pushed the average interest rate for a two-year loan to above 6 percent this week, was driven by financial market speculation about what the central banks will do next, as inflation continues to be stubbornly high.
Investors have re-evaluated how far they think the BoE will need to raise rates after a flurry in recent weeks of inflation data that was hotter than expected. This has caused a steep drop in the short-term UK Government debt which is sensitive to changes in BoE interest rates. The yields on two-year gilts, which increase as prices decline, rose above 5% for the first since 2008.
Interest rate swaps, closely related to mortgage lending, followed. Swaps allow two parties exchange payments with a fixed rate of interest for another stream at a floating rate tied to BoE rates. They are used to speculate on rate movements or hedge against them.
These swaps are also an important input for funding costs at banks. They use them frequently to compensate mismatches in fixed-rate assets, such as the vast majority of UK Mortgages and floating-rate liabilities, such as interest payments to holders of current accounts. In order to maintain their profitability, banks will pass on the costs of swaps to mortgage borrowers if rates increase.
The two-year swaps, which are significant because they’re often used to finance mortgages with a fixed rate of interest for two years, hit 5.64 percent on Tuesday. This is a rise of more than one percentage point from the last meeting of the BoE monetary policy committee in May. Over the same time period, five-year swaps rose by one percentage point to 4.93 percent. Mortgage pricing is affected by many factors, including the bank’s willingness to lend, the condition of its loan portfolio, and the credit rating of the borrower.
In practice, however, swap rates are used as a benchmark for mortgage rates. Ray Boulger is an analyst with mortgage broker John Charcol. He said that lenders usually look for a minimum of 0.5 percentage points difference between the swap rate and the mortgage rates they charge. However, at the moment, “some margins are very fine”.
The two-year fixed rate mortgages remain below the 6.53 percent reached in autumn last year after former chancellor Kwasi Kwarteng unveiled PS45bn in unfunded tax reductions.
The dynamics of the surge in rates this time around are very different. The rate surge this time was due to a more difficult inflation outlook, as opposed to the September shift which was triggered primarily by a general loss of confidence in UK policy.
In contrast to last autumn, lenders have returned to the market in a matter days, with more expensive products, rather than waiting and awaiting more certainty. This reflects a more stable market. Analysts warn, however, that it’s more likely this time that rates will remain higher for a longer period of time.
Experts predict that mortgage rates will continue to rise before they start to fall, because it takes some time for the rising swap rates in mortgage rates be reflected. Boulger stated that it may take “days” or even weeks for banks to update their IT systems before mortgage rates are recalculated. The amount of swap rates that had been fixed also played a role.
Boulger said that mortgage rates are still catching up with the current state of the gilt and swap markets. Watch the market on Thursday and Wednesday to see what they do next.
The UK will release its May inflation figures on Wednesday. If they continue to exceed expectations, this could lead to higher borrowing costs. Reuters polled economists who expect UK core inflation to remain high at 6.8 percent in May. This excludes volatile energy and food prices.
Markets expect the Bank of England to increase rates by 0.25 percentage points to 4.75 percent on Thursday. However, they also place a 25% probability that it will raise rates to 5%. The BoE will be closely monitoring communications to get any clues on the next rate move.
Many investment banks believe that the markets have overestimated their expectations of rates. The swap markets are currently pricing in a maximum of 5.82 percent for early next year, a full percentage higher than what was quoted at the last Bank of England meeting on May 11.
Mortgage rates may soon begin to drop if swaps rates start to decline, even as the BoE increases interest rates. Lyn Graham Taylor, senior rates strategist at Rabobank, said that the market has priced in too many interest rate increases for the BoE. Mohit Kumar is the chief European economist for Jefferies. He expects that the BoE’s rate will peak at 5%.
Theoretically, a drop in swap rates would push mortgage rates down as banks compete for customers. The lag between the swap market and the mortgage rate is usually longer when the swap rates are falling than when they are rising, as banks try to protect their margins.