UK mortgage rates have soared as the Bank of England raised borrowing costs over the past 18 months. But the latest jump, which carried the interest rate on the average two-year loan above 6 per cent this week, has been driven by frenzied speculation in financial markets about what the central bank will do next as inflation remains stubbornly high.

Why are mortgage rates rising?

A flurry of hotter than expected inflation data in recent weeks has led to a big rethink among investors about how far the BoE might have to lift interest rates. That has led to a sharp sell-off in short-term UK government debt, which is highly sensitive to moves in BoE rates. Two-year gilt yields, which rise as prices fall, climbed above 5 per cent for the first time since 2008 on Monday.

The closely linked market for interest rate swaps has followed, which had a knock-on effect on mortgage lending. Swaps are derivatives that allow two parties to exchange a stream of payments at a fixed interest rate for another at a floating rate pegged to BoE rates. As a tool for speculating on, or hedging against, rate moves, they represent the market’s best guess of what the central bank will do next.

They are also a crucial input in funding costs for banks, which frequently use them to offset mismatches between fixed-rate assets such as the majority of UK mortgages, and floating-rate liabilities such as the interest paid to current account holders. If rates rise on swaps then banks are typically forced to pass the cost on to mortgage borrowers to ensure their lending remains profitable.

Two-year swaps — which are important because of the prevalence of two-year fixed-rate mortgages — hit 5.64 per cent on Tuesday, rising more than a percentage point since the BoE’s last monetary policy committee meeting in May. Five-year swaps have risen by a percentage point over the same period to 4.93 per cent.

There are many other factors that feed into mortgage pricing, such as a bank’s appetite to lend more, the state of its existing loan book and the credit score of the borrower.

But in practice, swap rates act as a floor for mortgage rates. Ray Boulger, an analyst at mortgage broker John Charcol, said lenders typically looked for a difference of at least 0.5 percentage points between swap rates and what they charged on mortgages but at the moment “some of the margins are quite fine”. 

How does the market compare with ‘mini’ Budget levels? 

Two-year fixed mortgage rates remain below the 6.53 per cent reached last autumn after former chancellor Kwasi Kwarteng announced £45bn of unfunded tax cuts.

Importantly, the dynamics behind the rate surge this time are different. Rates have rushed higher owing to an increasingly difficult outlook for inflation, in contrast to September’s shift, which was triggered by a broader loss of confidence in UK economic policy.

Unlike last autumn, lenders are returning to the market within a matter of days with more expensive products rather than withdrawing and waiting for more certainty, reflecting more stability in the market. But analysts warn that this time it is more likely that rates will stay higher for longer, at least until the market is confident the Bank of England has brought inflation under control.

Will mortgage rates keep going up?

Experts predict mortgage rates will move higher still before they come down because it takes time for rising swap rates to be reflected in mortgage prices. Boulger said it could take “days or weeks” for mortgages to reprice as banks updated their IT systems. It also depended on the volume of rates they had already fixed through the swap market.

“At the moment, mortgage rates still have some catching up to do with where the gilt market and the swap market is,” said Boulger. “Watch the market on Wednesday and Thursday to see where they will go next.”

On Wednesday, the UK will publish inflation figures for May, which could push borrowing costs higher if they continue a trend of overshooting expectations. Economists polled by Reuters expect UK core inflation — which strips out volatile food and energy prices — to stay elevated at an annual rate of 6.8 per cent in May.

On Thursday, the Bank of England is broadly expected to deliver a 0.25 percentage point rate increase to 4.75 per cent, but markets place a 25 per cent probability that they will go further and push rates up to 5 per cent. Traders will be watching communications from the BoE closely for any hints on where rates could go next.

How quickly will rates come down?

Several investment banks think markets have been overzealous in their rate expectations, with swap markets at present pricing in a peak of 5.82 per cent early next year — a full percentage point higher than when the Bank of England last met on May 11.

This means that mortgage rates could soon start to fall if swap rates pull back — even as the BoE continues to increase interest rates. “I think it’s fair to say the market is pricing in too many rate hikes for the BoE,” said Lyn Graham-Taylor, a senior rates strategist at Rabobank. Mohit Kumar, chief European economist at Jefferies, expects the BoE rate to peak at 5 per cent.

In theory, a fall in swap rates should push down mortgage rates as banks compete to win customers. However, the lag between swaps and the mortgage market is typically longer on the way down than on the way up as banks seek to protect their profit margins.