Rising swaps: the US, the UK, and geopolitical risks

Words by Peter Stimson , Head of Product, Pricing and Proposition

Following Andrew Bailey’s comments on the 3rd of October that the Bank of England "could be more aggressive with its rate cuts," swap rates have unfortunately moved in the opposite direction. As of the time of writing, they are around 20 basis points higher than they were this time last week.

Given that swap rates have been on a gradual, albeit bumpy, downward curve since the start of July, and lenders have been reducing their interest rates accordingly, we are now likely to see a reversal, with banks needing to increase rates in the next few days or so. Banks have been aggressively cutting mortgage rates over the last two months and have largely been operating on wafer-thin margins. My assumption is that they will not be able to absorb this current increase in swap rates for any extended period.

So, the question is: why have swap rates gone up, and is this likely to be just a temporary blip? As always, the answer is complex, with several factors at play. Firstly, there is the influence from the US. Speculation has arisen that the US may be facing an economic slowdown or recession, and in response, the US Federal Reserve has started cutting interest rates. On the 19th of September, we saw a 50 basis point cut. In the US, as in the UK, there is now speculation about how fast and when further rate cuts might happen.

US payroll data, released at the end of last week, anticipated the addition of around 150,000 jobs. However, the actual number was 254,000, clearly indicating the US economy is more robust than expected. In response, expectations around the extent and timing of future rate cuts have shifted, with JP Morgan now predicting that, at the next meeting in early November, rates might only drop by a quarter of a percent, instead of the expected half a percent. Given that the US is the world's largest economy, these developments have ripple effects in the UK and Europe.

The second important factor, and the elephant in the room, is Rachel Reeves’ upcoming budget. Unless you’ve been living under a rock, you’ll be aware of the £20 billion black hole. Rumors are circulating that she may relax borrowing rules to help fund her budget and long-term government ambitions. This has made gilt investors very nervous, with the 10-year gilt yield rising nearly 50 basis points over the last three weeks. Since swaps are backed by gilts (as demonstrated by the Truss/Kwasi debacle), any increase in government borrowing costs will be felt by borrowers.

Finally, there is the issue of the Middle East and oil prices. At the moment, the oil price is surprisingly stable. However, the region is a tinderbox, and the potential for disruption to a commodity with inelastic demand could significantly impact inflation. This, in turn, could derail the Bank of England's goal of achieving its 2% inflation target and complicate decisions around when and whether to cut rates.

In the short term, all eyes are on Rachel Reeves and geopolitical events. When the Bank of England next meets, hopefully, there will be more clarity on at least one of these issues.