Why the mortgage market is in turmoil - We Analyse

We wrote back in September last year warning homeowners of a mortgage shock that was on its way as the Bank of England (BOE) started to raise interest rates quite aggressively to tame inflation which at the time was running at 10.1 per cent, well above the BOE's target. At the time, economists and the bank thought inflation was transitory and interest rates would not have to climb as high.

In September, the base rate was at 1.75%. It has increased to 4.5%, and experts forecast it to surpass 5% by autumn and potentially stabilise at 5.5%. The ONS's publication of inflation and unemployment figures caused a change in this trend.

Markets widely expected inflation to fall back into single digits, which it did, now at 8.7 per cent from 10.1 per cent. However, the core inflation, which strips out food and energy costs, rose from 6.2 per cent to 6.8 per cent. This indicates that inflation has become embedded in the UK economy, meaning that the BOE will have to raise interest rates even higher to get inflation back down to its target of 2 per cent.

How does this impact the mortgage market?

Even though the BOE's base rate had risen to 4.5 per cent, the swap rate, or SONIA (Sterling Over Night Indexed Average), had stayed below the base rate allowing banks to reduce mortgage rates. Swap rate or SONIA is the rate at which banks lend each other money, which informs their mortgage product rates instead of the BOE's base rate. The swap rates are priced on the future expectations of the BOE's base rate and are usually based on two-, five- or ten-year projections.

What led to the mortgage market turmoil?

The turbulence in the mortgage market escalated this week as the ONS reported that wages grew at the fastest pace in nearly two years and employment hit a record high. The ONS reported that weekly earnings, excluding bonuses, rose 7.2 per cent over the 12 months to April, up from 6.2 per cent in March. Wage growth is a key indicator of inflationary pressures, with the latest figures indicating that price growth will remain stubbornly high, which means that BOE will have to raise interest rates even higher to control inflation.

The mortgage market turmoil directly resulted from SONIA swap rates shooting up as markets started to price higher-than-expected base rate rises from the BOE after the wage growth date was released. As the table below highlights, the two-year swap rate as I write has gone up from 4.43 per cent on 15th May to 5.39 per cent, and the five-year swap rate has risen to 4.7 per cent from 3.9 per cent (Rates correct as of 14th June)

In both the rate increases, you will note that before the data for wage growth was published, the swap rates were below the BOE's base rate, meaning that banks could offer mortgages at competitive rates. However, as swap rates increased dramatically, banks had no option but to pull existing products or increase rates across their mortgage product range as they had to pay more to borrow.

HSBC became the first big lender to withdraw all its loans within an hour's notice. This was followed by Nationwide, Santander, TSB, Coventry building society and other big lenders raising interest rates across their mortgage range. The graph below highlights that the average two- and five-year fixed rates deal rose sharply. According to the Financial conduct authority, 116,000 households are coming off a fixed-rate deal this month, which will cause significant pain to households already facing a squeeze on living standards.

Analysis by Capital Economics found that a third of households, equivalent to 3.2 million, are paying interest rates of 3 per cent or more. By the end of next year, that will have risen to 5.8 million as the impact of higher interest rates passes through the market.

Over the next nine months, the mortgage market will undergo a significant reset due to rate increases impacting one-third of mortgage holders, with two-thirds still to come. Those coming off fixed rates in the next 12 months will face the largest repayment increase due to rising rates. This will also affect house prices, which will continue to fall during this period.