How Interest Rates Work (Updated)
Since I first posted this blog back in March, I thought it was worth revisiting this as the rate outlook has done a 180. This is why taking regular temperature checks on market rates are just so important
How Mortgage Rates Work (revised for October 2019)
As it would appear that Brexit is now the DFS sale of politics, and will simply go on, and on, and on… forever… (sadly this joke still works…)
As we adjust to this new norm, I have taken a step back to look at some basic market fundamentals to see where we are and what we can learn.
In essence, funding for a mortgage is actually very simple (or I would not be able to understand it…). There are 3 key factors to consider – LIBOR, 2 Year SWAP rates and 5 Year SWAP Rates and the relationship between them. By understanding how they relate to one another, you can start to see how funders view the market which therefore helps shape a clearer picture of the future.
How these work are as follows:
LIBOR stands for London Inter Bank Offer Rate (as most money cleared worldwide goes through London. That is a longer story to explain why, but basically it’s because London rules the world :-). LIBOR is a true reflection of the rates at which Banks lend to one another and typically funds Tracker Mortgages. LIBOR tries to guess when the Bank of England will move their Base Rate. I was taught all the way back in 2003 (when I became a broker), that when 3 Month Sterling LIBOR reaches 0.25% above or below the current Bank of England base rate (currently at 0.75%) expect a rate move in that direction, in the next 3 months, as the Bank of England typically moves the Base Rate in 0.25% chunks. I track this closely as it hugely impacts on the advice we give. As of Friday LIBOR was at 0.760%, which tells me there is about a 4% chance of a rate decrease in the next 3 months (the % difference between 0.75% and 0.5% and where LIBOR currently sits). That hints that the Bank of England will most likely move rates down next, but just not in the next 3 months (as the tipping point is being more than 50% of the difference, so in this case, LIBOR being below 0.625% for a period of time). This is a 180 switch from when I last wrote this article, as expectations were that rates would rise next, not fall. This means we have an inverted yield curve, meaning expectations in the future are worse than what we see today. Not a great message, but it is what is and we need to respond to it. By ‘worse’ that could mean lower economic growth, lower expectations of wage inflation or even job losses on the horizon. As a rule, when rates are expected to go down in such a low interest rate environment, that is more a reflection of the wider economy being weak, so by lowering rates it is cheaper to borrow and more people have money to spend. The picture a bit more complex currently with Brexit looming and the impact that is having on currency inflation as much as underlying inflation (which is typically calculated by the Retail Price Index – RPI).
Huge word of caution here is that this is the “market expectation” and is by no means a guarantee. We have seen quite large increases in LIBOR the last few years but yet the Bank of England haven’t moved rates. This is very much an art, not a science as so many factors play a role in when the Bank of England move rates, like Inflation and Wages etc. LIBOR also reflects the availability of money as well as cost. As I touch on above, I think this is more an indication of confidence in the UK economy as much as anything else. With such a nominal difference between LIBOR and the Bank of England Base rate, I do not expect anything to happen any time soon. Which is a logical stance until we know what (if anything) is going to happen on the 31st October. And therein lies the real issue, unless we know what the future actually is, how can we plan for it? That is the current Brexit paradox. Its like going on holiday and not knowing where you are going. Do you pack your Makini or Silver Salopettes? (neither are advisable in any situation that said, but you get the point). Another note of caution is that due to recent issues around LIBOR rigging, that index is due to be abolished in 2021. Common view is that it will be replaced with SONIA (Sterling Over Night Index Average). Plans are still very vague but this is something we are keeping a very close eye on and will be updating you on in due course.
2 & 5 Year SWAPs work exactly the same way. These are the money market rates guessing where rates will be over the next 2 or 5 years which has a huge impact on the price of Fixed Rate mortgages. As of Friday, 2 year money was at 0.675%, which tells me banks are expecting one rate cut in the next 2 years. 5 year money was at 0.620%, which tells me a very similar story and also the same as that of LIBOR, so I won’t rehash that point here.
That all paints a very negative view of the economy which I don’t agree with. There is no doubt we have many obstacles ahead and the economy may get worse before it gets better. I personally think rates will go up faster in the next 3, 4 or 5 years than may expect, which means the economy will also be growing. Again, the standard word of caution here that no-one knows where rates will ultimately go, it is all educated guess work. However, I believe that people are disproportionally influenced by recent events. So the doom and gloom surrounding Brexit has impacted here I feel.
So in my humble opinion, and on balanced reflection, I still feel that makes 5 year fixed rate deals look great value at the moment if you are coming at this purely from a cost perspective.
I have added a graph below so you can see the interplay of these aspects:
Banks will then apply whatever margin they feel appropriate to the above market rates. That will then take into consideration your personal situation like credit profile, income, deposit etc. Hence why speaking to an adviser is so crucial. As a guide, the best rates on the market will be above 0.75% + the benchmark rate (however we haven’t seen 5 year fixed rates come down as much as market rates have done over the last couple of months), but if you have a very complex situation that could be as high as 4% + the benchmark. The advantage is that no matter how complex your situation, money is cheap. If you go back to November 1999 when I started in mortgages, the Bank of England base rate was at 5.5%, which meant a market leading rate would have been around 6.25%! Irrespective of the wider situation, if your situation permits it, take advantage of this stupidly cheap money.
The above is all well and good, but if you have a specific need, your own view on rates or set situation, it then a case of finding the most suitable product, not just ‘cheapest’. That is why advice always plays a role as it is not a ‘one size fits all’ policy. Also, one of our core values if getting our clients debt free as soon as possible. With money so cheap, it has never been so possible to deleverage (pay off debt) so quickly. Don’t miss this window, as I’m sure we all hope the economy picks up over the next few years, which will mean in turn interest rates will also be on the up. Only a fool would try and call such a complex market, but if we look historical trends, there is no denying we are at or near the bottom of this rate cycle, so this again reinforces my view that locking into a longer term fixed rate now will reap dividends down the line.
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