How the bond market raises UK mortgage rates

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UK mortgage rates have risen with the Bank of England raising borrowing costs over the past 18 months. But the latest jump, which took the interest rate on an average two-year loan above 6 percent this week, has been fueled by frantic speculation in financial markets about what the central bank will do next as inflation remains high.

Why do mortgage rates rise?

A flurry of hotter-than-expected inflation data in recent weeks has prompted a major rethink among investors about how far the Bank of England may have to raise interest rates. This led to a sharp sell-off in the UK’s short-term government debt, which is highly sensitive to the Bank of England’s interest rate movements. Two-year Treasury yields, which have risen as prices fell, rose to more than 5 percent for the first time since 2008 on Monday.

This was followed by the market for closely linked interest rate swaps, which had a negative impact on mortgage lending. Swaps are derivatives that allow two parties to exchange a stream of payments at a fixed interest rate for another party at a floating rate linked to Bank of England rates. As a tool to speculate on or hedge price movements, it represents the market’s best guess as to what the central bank will do next.

They are also an important input into banks’ financing costs, which they frequently use to compensate for the mismatch between fixed-rate assets such as the majority of UK mortgages, and variable-rate liabilities such as interest paid to current account holders. If interest rates on swaps go up, banks usually have to pass the cost on to the mortgage lenders to ensure their lending remains profitable.

Two-year swaps — which are significant because of the proliferation of two-year fixed-rate mortgages — hit 5.64 percent on Tuesday, up more than a percentage point since the Bank of England’s last Monetary Policy Committee meeting in May. Five-year swaps rose by a percentage point over the same period, to 4.93 percent.

Many other factors feed into mortgage pricing, such as the bank’s appetite to lend more, the state of its current loan book and the borrower’s credit score.

But in practice, swap rates act as the bottom line for mortgage rates. Lenders are usually looking for a difference of at least 0.5 percentage point between swap rates and what they charge for mortgages but right now “some of the margins are pretty good,” said Ray Bolger, an analyst at mortgage broker John Charcoll.

How does the market compare to “mini” budget levels?

Fixed two-year mortgage rates are still below the 6.53 per cent reached last autumn after former chancellor Kwasi Quarting announced £45bn of unfunded tax cuts.

Importantly, the dynamics behind this time’s price increase are different. Prices were pushed higher by the increasingly difficult inflation outlook, in contrast to the turnaround in September, which was triggered by a widespread loss of confidence in UK economic policy.

Unlike last fall, lenders are returning to the market in a matter of days with more expensive products rather than withdrawing and waiting for more certainty, reflecting more stability in the market. But analysts warn that this time around, rates are likely to stay high for longer, at least until the market is certain the Bank of England has managed to keep inflation under control.

Do mortgage rates continue to rise?

Experts predict that mortgage rates will move higher before they fall because higher swap rates take time to be reflected in mortgage rates. Repricing mortgages could take “days or weeks,” Bolger said, while banks update their IT systems. It also depends on the volume of prices that have already been set through the barter market.

“Right now, mortgage rates still need to catch up to where the gold market and the swaps market are,” Bolger said. “Watch the market on Wednesday and Thursday to see where they go next.”

On Wednesday, the UK will publish inflation figures for May, which could push borrowing costs higher if it continues on the trend of beating expectations. Economists polled by Reuters expect UK core inflation – which excludes volatile food and energy prices – to remain high at an annualized rate of 6.8 per cent in May.

On Thursday, the Bank of England is widely expected to deliver a 0.25 percentage point increase to 4.75 per cent, but markets are placing a 25 per cent probability that it will go further and push interest rates to 5 per cent. Traders will be watching the calls from the BoE closely for any hints as to where prices could go next.

How fast are prices falling?

Many investment banks believe markets have been overzealous about their rate forecasts, with current-rate swaps markets peaking at 5.82 per cent early next year — a full percentage point higher than when the Bank of England last met on May 11.

This means that mortgage rates could soon start to fall if swap rates decline – even as the Bank of England continues to raise interest rates. “I think it’s fair to say that the market is pricing in a lot of BoE rate increases,” said Lynn Graham-Taylor, chief rate strategist at Rabobank. Mohit Kumar, chief European economist at Jefferies, expects the Bank of England rate to peak at 5 percent.

In theory, lower swap rates should lead to lower mortgage rates as banks compete for customers. However, the spread between swaps and the mortgage market is usually longer up the road than up as banks seek to protect their profit margins.

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