22.06.09 by Rob Gill
Economic View - Why Are Fixed Rates Rising?
Following announcements from Nationwide on June 12th that their fixed rate would rise by up to 0.86%, the last 10 days have seen fixed rate mortgages rise sharply across all maturities as other lenders scrambled to follow suit.
For many borrowers, such an increase in fixed rates while base rate remains at a 300 year low, and looks set to remain there for several months, invokes a mixture of confusion and anger at lenders ‘unfair’ behaviour. While it’s certainly true that lender’s are raising rates to ration scarce funds and rebuild profit margins decimated by the credit crunch, it’s also true that the underlying cost of funds has risen substantially in recent weeks, and that there are sound economic reasons for them having done so.
There is much talk from lenders and marker commentators about Swap rates, often in the context “due to a dramatic increase in swap rates....”. We know what comes next, although it rarely includes any explanation as to why an increase in these mythical swap rates means an increase in our mortgage rates.
Swap rates refer to instruments by which a floating or variable rate can be converted into a fixed rate. They are often funded by pension funds, who need fixed rate returns to fund liabilities such as annuity payments. They therefore provide funds to lenders, who then lend them to customers in the form of fixed rate mortgages.
In order to understand why the current economic environment has pushed up swap rates and in turn fixed rate mortgages, one also needs an understanding of the bond market. Bonds are the instrument by which sovereign governments borrow money, and UK government bonds are known as gilts. Government borrowing has hit the headlines recently, firstly with the announcement of Quantative Easing (or “Printing Money) and latterly with the huge sums of money the UK government are projected to borrow in coming months and years.
Gilts pay a rate of interest or “coupon” to the purchaser or lender, otherwise referred to as the yield. Gilts are actively traded on bond markets, causing the yields to fluctuate minute by minute according to investor’s appetites. This liquidity and yield or coupon makes gilts another useful source of fixed rate returns to pension funds, so ultimately the government and gilts are in competition with mortgage lenders to borrow funds. There is therefore a direct correlation between bond yields (the rate of interest obtained lending money to the UK government) and swap rates.
Lending to the UK government, with its top class credit rating and record of never having defaulted on its debt, is generally regarded as “risk free”; events of the last 2 years have shown how lending to a UK mortgage plainly isn’t. Pension funds therefore demand a risk premium for lending to banks via swap rates.
Bond yields have risen substantially in recent months. The benchmark guilt, which is used as a measure for all other maturities, is the 10 year gilt. Having dipped below 3% in March (following the announcement of the Q.E. programme), the yield on 10 year gilts rose to above 4% by mid June. Swap rates, and therefore mortgage rates, inevitably followed suit.
Such an increase in bond yields is a typical feature of this stage of an economic cycle. March was the end of Q1, a quarter which saw a brutal 1.9% decline in GDP. Since then genuine “green shoots” have started to emerge, prompting some economists to state that the recession may already be over, and this increased optimism has two main effects on bond yields.
Firstly, it causes expectations that, having been cut to fuel the economy, the official (i.e. base) rate will rise sooner than previously expected. Secondly, improved economic prospects invoke speculation that returns on other assets, such as equities and property, will rise, and therefore bond yields must also rise to attract their required share of investment. This second factor is perfectly illustrated by comparing 10 year bond yields with the FTSE 100, both of which show a 6 month low in March followed by a strong rally to highs in early to mid June.
So despite base rate remaining at 0.5%, the improvement in prospects for the UK economy have had an effect on bond yields in line with economic theory. The global economy has moved from a position of genuine concern over the survival of the global banking system with historic lows on stock markets and bond yields worldwide, to one of far less concern over financial institutions and genuine signs of full blown economic recovery. In the current environment, it is these economic factors and their effects on bond markets which drive mortgage rates, far more than our own Bank of England’s MPC.
Monty’s Mortgage Blog
19.08.10
Mortgage Lending Up...A Bit
Today saw the release of the latest set of data from the Council Of Mortgage Lenders, (CML) stating that Gross Mortgage Lending rose by 5% in July compared to June, although this is still 3% down from July 2009.
Coreco
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