What is a swap rate?
Very simply, a swap rate represents the cost to a lender of borrowing money over a given period of time – whether that be two years, three years, five years or longer – on any particular day, over that period. In short, it’s a reflection of the market’s view of how much that money will ‘cost’ over that period for the bank to ‘swap’ variable rate money and in return, receive a fixed coupon.
Swap rates are a contract by which two parties exchange future cash flows. For mortgage lenders, this means they can exchange variable rate funding and receive fixed interest payments to ensure there is no interest rate mismatch. This hedging of interest rate risk allows lenders to provide fixed rate mortgages to consumers.
Without a swap in place, lenders whose books have a high proportion of fixed rate lending, would be very vulnerable to interest rate change, as for example, when rates and variable funding costs rise there would be no corresponding rise in payments from borrowers who were remaining on fixed rate mortgages, leading to a mismatch.
By entering into a swap, lenders mitigate this risk, as the swap counterparty receives fixed payments and pays the lender variable as part of the swap transaction therefore ensuring the lender is ‘whole’.
What are swap rates based on?
Swap rates are intrinsically linked to UK Treasuries or gilts or more simply, the cost of government borrowing at any given time, given that gilts give a fixed coupon which is used to facilitate the swap. On top of the spread, the swap provider will also require a fee for the risk of the counterparty.
In the current market, inflation is the biggest factor of all, leading to the market anticipating future rises in the Bank of England base rate. Given the volatility here it is leading to lots of uncertainty and fluctuations in rates.
Inflation is proving very sticky
The biggest challenge the market faces is that inflation is proving very intransigent. Whilst energy costs are expected to fall, food, raw materials and other costs are still at record highs and there is no certainty as to when inflation will fall and how this then impacts rates.
For any of you expecting a return to rates below two per cent, I would suggest the last 15 years will come to be seen as an aberration in the wider scheme of interest rate history.
How can brokers use swap rates to advise their clients?
Currently, we have an inverted yield curve, where rates are lower the longer the time horizon. It has been like this now for a considerable time, but there is no real consensus about when rates could come down and if you looked at swaps curves a few months ago, the forward rate predictions would look quite different as the picture is constantly evolving.
I’m not trying to forecast interest rates, but I think it’s useful for brokers to understand the direct correlation between swaps and fixed rates and understand the direction of travel.
Just being aware of swap movements can give you a few days’ head start on likely product changes and help give your client some more information.
Swaps are a good barometer of where the next Bank of England base rate movement is likely to be and where interest rates are likely to be longer term. The markets are not always right, but in the absence of anything else, it’s as good as we’ve got to go on.
It’s clearly about the most challenging time to be giving advice that I can recall since I started working. Given the uncertainty, it’s even more important to understand the needs of the customer and understand what will work best for them beyond just the headline rate.
Customers need professional advice more than ever.
