Of Swaps & Spreads: What Drives Swap Rate Movements?
Understanding the intricacies and drivers of mortgage pricing is crucial for mortgage advisors. Fixed-rate mortgages make up the majority of mortgage lending in the UK, and the headline rate can be decomposed into two elements, the swap rate at the relevant maturity, for example the 2 or 5 year SONIA rate, and the “spread” (sometimes called the margin) over this swap rate, set by the lender.
Headline fixed rate = Swap rate + Spread
In this series of blog articles, we look at why the swap rate is relevant for banks, drivers of the swap rate, and drivers of the spread.
Here we look at what drives swap rates. Swap rates are determined by financial markets (much like share or bond prices) and are continuously in motion given changing dynamics.
What is a Swap?
In simple terms, a swap is a financial agreement to exchange future interest payments. One party agrees to pay a variable interest rate, like SONIA, while receiving a fixed rate in return. This helps banks manage the interest rate fluctuations they face when offering fixed-rate mortgages.
Inflation Expectations & Interest Rate Responses
Given the above, one of the key drivers of the swap rate for a given maturity is how the reference short term floating rate, for example SONIA or the Bank Rate, is expected to change over the life of the swap. The market has expectations on this (see below graph).
The Bank of England (BoE) sets the Bank Rate in the UK with the aim of maintaining inflation at its 2% target. The Bank Rate is the main tool of the BoE to achieve this target, and as such interest rates and the inflation rate are inherently very closely linked.
How do inflation and interest rates interact? Very simplistically, when inflation goes up above target, interest rates need to go up to decrease inflation. Conversely, when inflation goes down below target, interest rates need to go down to increase inflation.
Turning to inflation’s relationship with GDP. On the demand side high inflation is associated with high GDP growth – this is often the case in developing countries. Low inflation (or even negative inflation) is associated with low GDP growth, with Japan over the last couple of decades being the textbook example here.
However, inflation can also be driven by supply-side shocks, such as increased energy prices (one of the drivers of inflation seen in 2022/2023). In this case, the above association between inflation and GDP growth can be broken, and we can see high inflation and low GDP growth.
Pieces of “News” that Swap Markets React to
Communications by the Bank of England
The Bank of England takes interest rate decisions every 6 weeks at the monetary policy meeting. The outcome of this meeting clearly provides “news” to the market on the short and medium term direction of travel of Bank Rate.
However, sometimes there is no significant “news” in the rate announcement itself, as the market had already expected it, so it was reflected in the swap rate before the meeting. For example, if the market was 100% confident in a bank rate hold, then a bank rate hold happening would not move swap rates (however any other “news” in the announcement would change swap rates).
As well as the actual bank rate decision, the breakdown of MPC member votes and commentary is also released to the public. This can contain important information on individual MPC members’ views and language in any commentary is closely scrutinised by the markets for any indication of potential direction of travel or change in stance.
One other source of news is MPC member speeches, which can sometimes contain more information on personal views than the vote decision alone.
Direct data on UK inflation
As the Bank of England takes decisions every 6 weeks, market participants can predict how the Bank may respond to key bits of macroeconomic data released between official decisions.
The key headline metric is the inflation rate, after all this is what the Bank of England is targeting. The market forms expectations about the inflation rate before its monthly release by the Office for National Statistics (ONS).
If the headline inflation rate is above expectations, this will have a knock-on impact on expectations for the evolution of bank rate, and as such the swap rate will increase.
Indirect data on UK inflation: GDP & Employment
Other data points, such as GDP and the unemployment rate contain important information on the future direction of travel of inflation. We discussed above the traditional relationship between GDP and inflation, higher GDP growth is traditionally associated with higher inflation.
High employment (low unemployment) is also associated with higher inflation, through the wage channel. The reasoning is that with low unemployment, workers have increased bargaining power to demand wage increases, which ultimately leads to firms raising their prices to maintain profits.
Policy moves from other countries
Britain is highly linked to global markets and other currencies’ rate decisions, particularly the Dollar and Euro, have an impact on the foreign exchange (FX) rate of the pound.
The FX market link can serve to increase dependency between the BoE and other rate setters, as without adjustment this FX impact can be inflationary or deflationary. As such, when the U.S. Federal Reserve (the Fed) or ECB take rate decisions, any unexpected moves can have a knock-on impact to Bank Rate expectations, and as a consequence the GBP swap rate.
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