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Why investors should consider five year fixed rate buy to let mortgages

Simon Whittaker reviews the Bank of England's latest Inflation Report incorporating its new “forward guidance” on future interest rates. So what do we know now that we didn’t know before? And how does it affect buy to let mortgage rates?

The Bank of England published yesterday its quarterly Inflation Report incorporating its new “forward guidance” on future interest rates. So what do we know now that we didn’t know before? And how does it affect buy to let mortgage rates?

The first and simplest message is that the Bank has learned not to publish a simple measurement that might cause people to get excited about future interest rates unnecessarily. The 7% unemployment figure was never intended by the Governor as a “trigger” for a rate rise – purely as an indication of a metric that might indicate that inflationary pressures were likely to be building within the economy. But unfortunately all too many commentators (who should have known better) treated it as such – and the “man in the street” was all too easily misled.

The most important single message to emerge from the report is that the Bank believes that market interest rate expectations will deliver CPI inflation that is very close to 2% p.a. over the next three years. Since this is the Bank’s key target figure, this is a coded way of saying that forward swap rates for up to three years should be a good guide to actual interest rates over the period.

Looking at the detail of the report – and in particular the section entitled “Monetary policy as the economy recovers” the messages are far more nuanced – but they are there nonetheless.

“With inflation expectations well anchored, and in the absence of external price pressures, the MPC can consistently achieve the 2% inflation target in the medium term only if the economy is operating close to capacity. When inflation is at target but the economy is operating below potential levels of activity, the MPC will, in the absence of other influences, set policy to stimulate demand to eliminate that spare capacity.”

Thus, rather than relying on a simple readily ascertainable metric such as unemployment rate, the Bank will be monitoring a somewhat more nebulous metric - namely “spare capacity” within the economy. It estimates that this is currently 1% - 1.5% of GDP, of which it attributes around half to the fact that unemployment at 7.1% is above the “medium term equilibrium” rate of 6% - 6.5%.

To my way of thinking that means 6.5% is the minimum rate at which the Bank thinks that a rise in interest rates might be warranted but unfortunately the Bank then goes on to muddy the waters somewhat by asserting that “the medium term equilibrium rate is likely to drift down as unemployment falls further” (why don’t they re-assess it now?). So maybe the first point at which the Bank would consider a rise in interest rates is closer to 6% - and that is not forecast (by the Bank) to be reached before 2017!

The report goes on to say:

“…. even when the economy has returned to normal levels of capacity and inflation is close to the target, the appropriate level of Bank Rate is likely to be materially below the 5% level set on average by the Committee prior to the crisis. Given that the headwinds weighing on the recovery are likely to persist for some time, when Bank Rate does increase, it is expected to do so only gradually.”

Which sounds great until you read:

“The actual path Bank Rate will follow over the next few years is, however, uncertain and will depend on economic circumstances. Bank Rate may rise more slowly than expected, and increases in Bank Rate may be reversed, if economic headwinds intensify or the recovery falters. Similarly, Bank Rate may be increased more rapidly than anticipated if economic developments raise the outlook for inflation significantly.”

This is either a statement of the bleedin’ obvious or else a major warning that none of the forecasts have any real credibility!

So if we ignore the uncertainties and confusions in the report and accept that market swap rates for three years ahead are a good guide to the likely outcome – what does this mean for the future of interest rates? Swap rates have been fairly volatile but based on the rates over 2014 to date the implied interest rates over the next 10 years are set out below and compared with the assumptions for the next three years used by the Bank in preparing its forecasts:

Year Rate Range BR Forecast Assumptions
2014 0.60% - 0.66% 0.5%
2015 1.24% - 1.49% 1.2%
2016 1.97% - 2.30% 1.9%
2017/18 2.83% - 3.23% -
2019/20 3.41% - 3.75% -
2021/23 3.73% - 4.07% -


Despite the arguments about the spare capacity within the economy it is clear that both the market and the Bank expect interest rates to rise within three years and whilst nobody can predict with any confidence when or how much they will move there is a clear expectation that term rates will also rise. So whilst the current swap rate for a five year term is around 1.93%, the swap for seven years is 2.36%. This would imply an expectation that in two years’ time the five year swap rate will have risen to around 2.9%.

Or to put it more simply your five year fixed rate mortgage is likely to cost around 1% p.a. more in two years’ time as an expectation of rates rising towards 4% in 2020 start to take hold.

Partly in response to the Bank’s report (and its bullish growth forecasts) yesterday we saw medium term swap rates jump by around 0.1%. Furthermore there are two significant uncertainties that could cause a significant increase in rates in 2014 (above those factored into existing swap rates). First of all there is the Scottish independence vote in September and the uncertainty that this is creating over the currency union and ultimately the servicing of UK national debt. Secondly, and probably more importantly, it is likely that the major UK political parties will soon start to move into pre-election mode – and this will doubtless serve to remind the markets of the risks and uncertainties thrown up by a potential change in economic policy if there is a change in Government. There can be little doubt that a more free-spending Government would be met by an increase in interest rates – and the mere possibility of this happening could of itself be sufficient to push up swap rates over the next few months.

Added to this is our belief that lenders have already absorbed a considerable increase in the cost of five year money – and some lenders have already increased their five year fixed rates in recognition of this. Put all of these factors together and we are confirmed in our belief that borrowers should give consideration to fixing their mortgages before rate rises are implemented by lenders.

But as the Bank observed:

“The actual path Bank Rate will follow over the next few years is, however, uncertain and will depend on economic circumstances.”

All I can say in response is "!!!!..."

If you would like to discuss any of the above points or have any questions around the matter, please feel free to contact me on my direct dial 01732 471622 or 07712051380

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