Interest rates

The roller coaster of mortgage interest rates

Anyone who has looked at mortgages lately may have noticed something surprising. If you want a two-year fixed-rate mortgage on a 60% loan-to-value ratio, you could get 3.82% from First Direct, for example. However, if you want a five-year solution, you will pay 3.58% to the same lender, i.e. a lower rate. And if you opt for a ten-year solution, the offer is 3.83%, only 0.01 percentage point more than the two-year one.

I’m using First Direct here because it’s a clear example of the point – their mortgage terms are similar and there aren’t huge differences in prepayment charges or other nuances. But the same goes for many other lenders.

It’s really not what you expect. The basic principle of a yield curve is that lenders expect higher rates for loans over a longer period. Sometimes government bond yield curves can be very flat or even slightly inverted, but such a small difference between five-year and ten-year mortgage rates is rare. I think the gap of about 0.25 percentage points in the example is about a third of what it has been over the longer term.

Pricing in a return to lower interest rates

So what’s going on? You can see the answer quite clearly if you look at what is called the overnight index trading futures curve (OIS), the data for which can be found on the Bank of England website. The OIS forward curve is essentially the forecast of interest rates at some point in the future. This is not the interest rate for such a long loan – it is simply what the rate is supposed to be at that time, implied by the market prices of interest rate derivatives. interest.

Thus, the Bank of England’s OIS forward curve now suggests that interest rates will be around 4.5% by the middle of next year. This is a sharp increase from what it implied just a month ago (around 2.5% to 3%) and significantly up from expectations of around 1.5% six months ago. . But the curve then predicts that rates will fall sharply and be around 3% by the end of 2025. That’s also up from forecasts from a month ago – when rates were expected to be 2 % in 2025 – but rose much less than expectations for rates next year.

This is why mortgage rates seem so high: the market expects much lower long-term rates, and so lending for longer periods takes this into account. It can happen – or it could suggest that markets are too slow to determine whether we are moving from a regime of low inflation/low rates to one where both are at more historically normal levels.

We won’t know for a while, but if the markets get it wrong, it will have huge implications for the pricing of all kinds of assets. However, for anyone looking for long-term mortgage security, the spread between five-year and ten-year rates looks particularly small – and may not last much longer if expectations change.