Short-Term UK Government Debt Sell-Off Affects Mortgage Lending

2023

Mortgage rates in the UK have been surging recently as the Bank of England (BoE) raised borrowing costs over the past 18 months. The latest increase pushed the average two-year loan's interest rate above 6 per cent, driven by frenzied speculation in financial markets about the central bank's next move due to persistently high inflation.

Hotter than expected inflation data led investors to reconsider how much the BoE might raise interest rates, resulting in a sell-off in short-term UK government debt. As a result, two-year gilt yields rose above 5 per cent for the first time since 2008, impacting the closely linked market for interest rate swaps and, subsequently, mortgage lending.

Interest rate swaps are crucial for banks as they help manage the balance between fixed-rate assets like most UK mortgages and floating-rate liabilities such as interest paid to account holders. When rates rise on swaps, banks pass on the cost to mortgage borrowers to maintain profitability.

Although many factors impact mortgage pricing, swap rates essentially act as a floor for mortgage rates. As swap rates have surged, mortgage rates are expected to continue rising before eventually coming down.

However, analysts predict that mortgage rates will remain high until the market is confident that the BoE has brought inflation under control. On Wednesday, inflation figures for May will be published, influencing borrowing costs, and on Thursday, the BoE is expected to raise rates by 0.25 percentage point to 4.75 per cent, with a chance of going further to 5 per cent.

Some investment banks believe that markets have been too optimistic in their rate expectations, leading to higher swap rates. If swap rates pull back, mortgage rates could begin to fall even as the BoE continues to raise interest rates. However, the lag between swaps and the mortgage market is typically longer on the way down, as banks aim to safeguard their profit margins.