What caught my eye this week.

After several false alarms, the past week saw National Grid throw the switch on its demand flexibility service.

Like much else in modern life, there’s a bit of double-speak going on here.

The ‘service’ on offer for those taking part actually involves degrading something we in the UK take for granted – electricity at the flick of a switch, whenever we want it, and the luxury of use without guilt or much thought.

Instead those who sign-up (and who must have a smart meter) are paid an incentive for using less power than they normally would during set peak periods.

For example, on Tuesday from 4.30pm to 6pm window.

According to The Guardian:

During the trials, typical households saved about half a kilowatt hour, which will be worth about £2 on Tuesday, putting the cost to National Grid at £2m. Those funds will be passed on to those participating, with suppliers keeping a share to cover their costs.

In total, National Grid is expected to pay just over £3m to suppliers for the service over Monday and Tuesday – with about £850,000 on the first day, and £2.1m for the longer session on Tuesday.

Octopus Energy – which has been running trials since early last year – reckons 400,000 of its customers took park in Tuesday’s session. They were offered £4 for each kilowatt hour of electricity they avoided during the hot zone.

(Interestingly, that incentive had been bumped up on account of National Grid lifting its payouts. Competition counts.)

In total more than £1m was paid out to Octopus customers on Tuesday. That’s meaningful money. But of course you have to divide it by the large number of customers taking part.

Which in turn leads to headlines like This Is Money’s ‘Would you switch off your cooker and washing machine for an hour to save 39p?’

Cognitive load

While the This Is Money angle rankles, I don’t blame it for going there. The small amounts saved do seem derisory if you pay attention to them.

Even doing it every week isn’t going to move the dial for many families. It’s been estimated that Octopus customers who took part in 25 powering-down events over winter might save just £100 in total.

That’s not nothing, but there are easier ways to save money than having to think about how you’re using energy a couple of dozen times for three months.

Instead, just remembering to never use big electrical appliances between 4.30pm and 6pm every day would cut the cognitive load. But at some point you’d presumably stop saving money that way, as your smart meter would get wind of your new pattern of usage.

Which means there’s actually an incentive to keep using power at peak times during the rest of the week. That seems a perverse incentive!

Vanishingly beneficial

With all that said, as a prophet of environmental danger myself I’m all for this direction of travel.

The key is for the system to become invisible, and ubiquitous. All consumers should have smart meters and their bills should be lowered whenever they use more energy outside of peak demand. These peak times should just become generally known, the same way we all understand that if we want to travel at rush hour there will be crowds.

Consumers shouldn’t have to police their bills to ensure they see savings. And in time AI and other smart home features should respond to known patterns of demand, too.

For example, you might switch on your washing machine at 5pm only for it to chirp back: “Do you want to wait until 6pm to save money?”

An emergency load can still get done. But I’d bet 90% of washes would simply be punted forward to beyond the peak period.

Every little helps

Apparently Tuesday’s scheme saved energy equivalent to the city of Liverpool shutting down for an hour.

That’s a result, and I think this will scale.

Critics of renewables understandably raise issues about intermittent supply, peak demand, storage and so on. There’s no single killer fix, but I believe there are myriad small fixes – from using electric vehicles as a vast distributed battery to devising fossil fuel power stations optimised explicitly for short-term back-up, to these sorts of energy demand schemes.

Nobody said it will be easy, but if saving the planet involves not tumble drying my underwear at 5pm on a Tuesday then sign me up.

After that signing though, I don’t want to have to think much about it. That’s crucial.

Enjoy the links, and have a great weekend!

[continue reading…]

For sure I’m not the only homeowner who has been refreshing their mortgage options every day for the past few months. But are you also following swap rates?

Swap rates might sound like the relative popularity of Lionel Messi versus Cristiano Ronaldo in the Panini sticker trading game.

But they’re actually a vital bit of the financial system plumbing.

Swap rates largely determine mortgage rates, as well as much else that’s numerical and curvy in the financial world.

By keeping an eye on swap rates, you can better understand why you’re offered a particular mortgage rate.

True, you probably won’t bag a huge bargain on the back of it. Your mortgage offer will mostly depend on your income and deposit.

But at least understanding swap rates can help you judge why a given mortgage may be slightly more attractive than another, say, compared to if you didn’t know how they were priced at all.

Let’s dig in.

What are swaps?

In finance, a swap is an agreement between two parties to exchange – or ‘swap’ – the cash flows from one asset for another, for a certain period of time.

Typically one stream of cash flows is fixed and the other variable.

Swaps are derivative contracts and the market is vast and deep. Estimates vary, but think hundreds of trillions of (notional) dollars, globally.1

There are various kinds of swaps, differing by whether the variable cash flow is tied to an interest rate, a currency exchange rate, or some kind of price level.

For example you may recall the Credit Default Swaps (CDS) made infamous by the financial crisis and The Big Short. CDS enable investors to swap or offset credit risk on fixed income assets.

The swaps we’re interested in today are called interest rate swaps.

Interested in interest rates

In an interest rate swap, the cash flows exchanged are interest rate payments.

Most commonly, the swap exchanges a stream of fixed-rate payments for floating-rate payments.

Investment banks arrange swaps for a fee. The investment bank later offloads the risk via brokers to other investors, who want exposure for their own reasons. (Hedging or speculation, say).

Commercial and investment banks, big corporations, and very large traders typically make up the two sides (counterparties) of swap contracts.

What is the swap rate?

The swap rate is the fixed rate demanded by one party in the swap for the uncertainty of having to pay the variable (floating) rates that the other party wants to exchange, over some period of time.

Here’s what’s going on:

The receiver demands a particular fixed interest rate – or ‘swap rate’ – from the payer. In exchange, the receiver agrees to meet the payer’s (uncertain) floating rate payments over time.

The swap rate reflects the expected value of those future floating rate cash flows, as predicted by the money markets when the deal is struck.2

At the time the swap is agreed, the two cash flows net out to zero and neither side stands to profit:

Source: PIMCO

In practice, variable rates are called variable for a reason. As the floating variable rate rises or falls, the contract will become profitable for one of the parties.

Note though that this doesn’t necessarily make the deal a bad one for the ‘loser’.

Think about when you take out a fixed-rate mortgage. The right reason to go for a fixed rate is to lock-in a regular and known cost for your future payments. It’s not to punt on interest rates.

Similarly, one party in a swap wants rid of the uncertainty caused by floating interest rates. If it loses a little money over time, that’s the cost of insurance.

Price moves everything around me

This all probably sounds very complicated, and on a deep level it is.

However, just as you don’t need to do a fundamental company analysis to buy Apple shares at the prevailing stock price, so participants in the swaps market basically follow the prevailing swap rate, which fluctuates with supply and demand.

• Here’s one data provider of current swap rates.

How do swap rates affect mortgage rates?

Swap rates are what determine mortgage rates (but see below for a bit on bank margins).

Of course you might ask “what determines the swap rate?” but this article would go on forever. The short answer is interest rates, and expectations and uncertainty in the market.

But back to mainstream lenders and mortgage rates.

Let’s say a mortgage bank is in the mood for lending.

Many of us believe High Street banks lend out the cash deposited by savers as mortgages, but this isn’t exactly how it works.3

A bank can create new money for loans via fractional reserve banking.

Alternatively it can tootle off to the money markets. There it might secure a couple of hundred million pounds worth of wholesale funding from other market participants.

It pays variable (/floating) rates on this money. However the lender wants to offer its customers fixed-rate mortgages, on which it will receive set monthly repayments. So there’s a mismatch here.

Even if the bank creates new money to make the mortgages, it’s in the business of providing retail customers with savings and loans, not in gambling on future interest rates. Also many of its liabilities will be related to floating rates, such as the interest it pays to savers.

So again, it will want to get rid of the risk inherent in offering a fixed-rate mortgage.

Enter the bankers’ bankers

In order to offer fixed-rate mortgages in a prudent and mostly risk-free fashion, our lender heads over to an investment bank.

These guys are only too keen to temple their fingers, smile menacingly, and arrange an interest rate swap that exchanges a variable cash flow for a fixed-rate cashflow.

Hey presto! The mortgage lender now has say £200m of money on which it will pay, for example, 4% for the next five years, thanks to the swap.

The investment bank is stuck with the risk of meeting the floating rate payments – but that’s its problem. (Which as I said earlier it will probably soon offload itself. But they are not the hero of this story, so we’ll leave them there).

The mortgage lender can now proceed to offer its customers £200m worth of fixed-rate mortgages at 4%. (Or a little more than 4%, because it wants to make a profit).

Crucially, the mortgage bank doesn’t have to worry about the variable rate going up to say 6%, and these fixed-rate mortgages becoming unprofitable.

It got rid of that interest rate risk, via the swap.

Bank competition also affects mortgage rates

If swap rates and mortgage rates were one and the same, then we’d have no need of comparison sites or shopping around. All banks would offer the same rates. At least for the same terms.

But in practice mortgage rates vary across lenders.

As I write, the average five-year fixed-rate mortgage is charging 5.27%, according to data provider Moneyfacts. But home buyers with a 25% deposit can bag a five-year fixed rate from Yorkshire Building Society costing just 4.18%.

This chunky gap between the best rate and average rate – more than a full percentage point, or 109 basis points in City lingo – reflects the difference in margin the banks aim to make from their mortgages, and how keen they are to win business.4

It’s not rocket science to see that a lower mortgage rate will attract more borrowers, all else equal.

But charging a lower mortgage rate will earn the bank less money – margin – too, reducing the profit per customer.

A lower margin also means there’s less ‘buffer’ in the cash coming in to meet the bank’s other obligations. This will especially matter if mortgage delinquencies rise (and it subsequently receives less of those expected fixed-rate cash flows).

Hence cheaper rates also reflects a bank’s willingness to take on more risk.

Banks juggle all this according to their strategy – market niche, confidence in their mortgage underwriting, and their balance sheet – as well as their usual herd behaviour.

(Bankers like to do what everyone else is doing!)

Remember when the Mini Budget blew up the market?

You can now see why mortgages got so expensive in the midst of the 2022 Mini Budget dysfunction.

Swap rates skyrocketed, partly because interest rate expectations spiked on the prospect of additional unexpected and unfunded government borrowing, but also because of a huge rise in uncertainty.

Spot the Liz Truss moment in this graph of two-year interest rate swaps:

Source: Investing.com

The spike in swap rates immediately impacted the future pricing for mortgages.

But the tumult also had a secondary affect, which was that mortgage lenders got the willies. They pulled thousands of their mortgage products in order to buy time to wait and see, and to price their products properly.

Thankfully, even this generation of Tories realized that the Liz Truss spectacular was a step too far in their post-Referendum battle against Britain’s prosperity.

So Truss got the chop and more sober politicians came in.

And we can see this clearly in the chart. Two-year swap rates are now back to where they were before the whole debacle.

Note that’s despite more interest rate rises from the Bank of England since. The market had already priced in those rises, prior to the possibility of additional ones due to ‘Trussonomics’.

Where does this leave the mortgage market?

The money markets have hugely calmed down since Liz Truss and Kwazi Kwarteng were ousted in favour of the comparatively trustworthy Rishi Sunak and Jeremy Hunt.

Whatever their pros (they’re not Tory ultras) and cons (they still spout fantasies about economic ‘Brexit benefits’), the pair have promised fiscal sobriety, no funny business, and to show their workings.

Foreign and domestic capital has taken them at their word. The bond vigilantes have stood down. The so-called moron premium in UK rates has mostly dissipated. And swap rates have declined from the distressed levels we saw during The Muppet Show of September 2022.

As you’d expect, that has brought mortgage rates down. Although sadly not quite to pre-Mini Budget levels.

For example:

• The average new two-year fixed rate mortgage was 4.74% just before the Mini Budget.

• The average rate for the same mortgage is 5.5% at the time of writing.

Why the 75 basis point gap?

It’s true the Bank of England has continued to hike interest rates. However the forward curves implied this even before the Mini Budget.

Sure, nailed-on rate rises are more convincing then ‘almost certainly’. But only unexpected increases in the rate or duration of higher interest rates should lift swap rates.

More probable I think is the outlook for the UK economy – and its housing market – has worsened since early September 2022.

That could imply the Bank of England won’t raise rates so aggressively.

Indeed the current swap rate curve implies the Bank of England will be cutting Bank Rate from the today’s 3.5% within a couple of years:

Source: Bank of England

However the Bank of England’s focus is currently on bringing inflation down to target. And progress here is still only modest. Visible, but modest.

What’s more, there’s clearly a ton of economic strife going on, with workers everywhere demanding double-digit pay increases. Big wage hikes are certainly inflationary.

Given all this, I wonder whether most of the banks have simply been looking at the fatter margins on their mortgage products versus last year, and not feeling any great rush to trim them?

In other words, the mortgage lenders remain more skittish than before the Mini Budget.

On the other hand, mortgage experts always said it would take a while for mortgages to re-price following the September ructions.

And mortgage rates are still inching down each week. The best fixed-rate mortgages are much cheaper than the average, if you can get them. Maybe the spread over swap rates will continue to close.

What does it mean for a would-be borrower today?

So should you look to get a variable or tracker-rate mortgage, at least for a while, and wait for lenders to bring fixed-rate mortgages down further?

Mortgage rates will probably continue to decline, but this isn’t a certainty. If the last year’s Russian war, energy price ructions, and political turmoil taught us anything, it’s that things happen.

On the other hand, while a variable rate mortgage will probably be more expensive to start with, it might be a price worth paying if you can switch to a sub-4% five-year fix in a few months time.

That’s not a prediction – but others are making it.

From FTAdvisor:

Brokers have shared their latest predictions on when fixed mortgage rates will fall below 4 per cent, with some saying they are likely to come down “by March” while others are “doubtful” rates will fall that low for at least the next six months.

As I noted earlier, one lender is already offering a 4.18% five-year fix. Others should follow.

However, as always, fixed-rate mortgages are chiefly about the certainty of forward payments, not interest rate speculation.

If you can truly afford (a) higher standard variable rate payments today and (b) the risk of having to eventually lock into a more expensive fix because ‘something happens’ tomorrow, then there may be a case for waiting a few months.

But what’s most important is to buy (or remortgage) at a rate that you can comfortably budget to and manage.

I’m keen to hear from other readers who’ve recently had to negotiate these mortgage markets. Anyone else watching swap rates? Or unfortunate enough to have remortgaged under Truss?

1. The majority of these contracts net off against each other. The actual cash flows involved are much more modest. []
2. In the UK that future is predicted by the forward SONIA (Sterling Over Night Index Average) curve. SONIA is the more transparent successor benchmark to LIBOR, which was rigged by banks during the financial crisis. SONIA is administered by the Bank of England. []
3. Savings aren’t irrelevant. But they are mostly cheap funding that bolsters the bank’s balance sheet, helping to enable its various other activities. []
4. It may also represent how much funding the bank has previously secured via swap rates. Once this tranche is used up, its rates will change with the cost of new funding. []

Better known as a global investment giant, Vanguard is currently paying a highly competitive interest rate on cash parked in its ISA, SIPP, and general trading account products. Vanguard doesn’t publicise it but you can currently earn a Vanguard cash interest rate of 3.0935% to 3.1% on money you leave uninvested in its platform. 

This ‘hidden’ Vanguard interest rate compares very favourably against leading easy-access savings accounts and cash ISAs topping the ‘best buy’ tables at the time of writing.  

Vanguard cash interest: how it’s calculated

Vanguard’s interest rate is calculated on your cash balance like this: 

The Bank Of England base rate (currently 3.5%)

minus 

0.25% Vanguard’s deduction from the base rate 

minus 

0.15% Vanguard’s account fee 

minus

Up to 0.2% Vanguard charge on interest received 

Note: the 0.2% is deducted from the interest you earn. It’s not a 0.2% fee applied to your total cash balance. That makes this charge much smaller than it appears at first glance, as we’ll see below.

Tot those numbers up and you’ll earn a minimum 3.0935% Vanguard cash interest on uninvested cash lying idle in a stocks and shares ISA, Junior ISA, SIPP, or general trading account. 

Vanguard interest rate: an example

Vanguard doesn’t publish its cash interest rate. It’s like a secret menu item at KFC.

Moreover, the clues to its existence are confusing, so let’s work through an example to see just how good the interest payments are.

Imagine you’ve stashed £10,000 in your Vanguard account. 

£10,000 x 3.25% Vanguard cash interest rate = £325 interest earned

£10,000 x 0.15% account fee = £15 deducted

£325 x 0.2% Vanguard admin charge on interest = £0.65 deducted

£325 – £15 – £0.65 = £309.35 net interest earned 

(£309.35 / £10,000) x 100 = 3.0935% Vanguard interest rate

Or: 3.5 – 0.25 – 0.15 – (3.25*0.002) = 3.0935% interest paid on cash. 

Right now, that’s a generous rate!

Are there any wrinkles?

Quite a few! Both positive and negative things to be aware of. 

Monevator reader WCTL Flashheart first tipped us off about Vanguard’s interest rates. WCTL Flashheart said the cash payments they received increased with every hike from the Bank Of England. 

In other words, Vanguard is quick to pass on the benefit of interest rate rises. Quite unlike some other financial institutions we could mention!

About that confusing interest charge

Vanguard’s cash interest rate is poorly advertised, to say the least. The fullest explanation is in the Vanguard Client Terms document. (Access the latest version from its terms and conditions page). 

This document says (emphasis is mine):

Interest charge

We do not charge a service fee for holding your cash. Instead we currently keep up to 0.20% of the interest rate we receive on cash held in your account, to cover our costs of administering it. This rate is determined by reference to the interest we receive and the cost to us of managing the cash within your Account.

In the event that we are not able to sufficiently recover our costs from the interest we receive we reserve the right to levy an additional service fee of up to 0.20% by written notice in accordance with clause 10.

If Vanguard decides not to levy the full 0.2% on interest received, then you’ll earn a slightly better rate: up to 3.1%. 

Reader WCTL Flashheart calculates they are earning 3.1% in their SIPP, for example. 

Meanwhile Vanguard customer service didn’t mention the 0.2% charge to me and say the interest rate is the same for all accounts. 

However, as you can see in the clause above, Vanguard may charge up to 0.4% on interest received. 

Thankfully that won’t do much damage. A charge of 0.4% on 3.25% reduces your Vanguard cash interest rate to 3.087%. 

What about this account fee and service fee business? 

Vanguard’s website says: “We do not charge a service fee for holding your cash.”

Many people might innocently assume that means Vanguard doesn’t charge its 0.15% account fee on cash holdings. 

But Vanguard customer service has confirmed that the 0.15% charge does count against cash. 

So while it’s lovely that Vanguard doesn’t charge a service fee, it does charge an account fee. Because those two things are, um, completely different, obvs. 

There is an account fee cap

Once the value of all your accounts (investments and cash) passes the £250,000 mark then your account fee tops out at £375.

So if you’re stuffing away cash at Vanguard beyond that threshold, you’ll earn a 0.15% bonus rate. 

Admittedly while simultaneously throwing away cash – because there are rival brokers who’ll charge you a much cheaper flat fee for holdings way below the £250,000 level.

(See the flat fee brokers section of our broker comparison table for a better deal.)

When is interest paid and are there any other catches? 

Interest is accrued daily, but you don’t earn a bean on cash awaiting withdrawal or cash that’s paid into a regular savings plan.

According to the client terms document: 

If you set up a Regular Savings Plan to make regular Payments or Contributions we will not pay interest on your Payment or Contribution before it is invested.

Is the cash ‘easy access’?

Cash parked in your Vanguard SIPP can’t leave until you hit the minimum pension age. That’s age 55 at best, so perhaps this route is for retirees only. 

Junior can’t withdraw from a Junior ISA until age 18. (Probably a good thing on balance…)

However you can withdraw anytime from a Vanguard stocks and shares ISA, or a general account.

Vanguard’s ISA is flexible so you can withdraw money and not lose that year’s ISA allowance if you pay back the cash inside the same tax year. Hit that last link for a refresher on the flexible ISA rules. 

Vanguard’s withdrawal terms are also pretty easy going:

There is no minimum withdrawal amount and no requirement to maintain a minimum account balance. 

Obviously though it’s not like moving cash in a flash on a banking app. It could take a good few days for your cash to actually land in your bank account. 

Please let us know in the comments if you have firsthand experience of how long it takes Vanguard to stump up after a withdrawal request. 

FSCS compensation protection

Famously, cash and investments are protected up to £85,000 by the FSCS compensation scheme. 

Vanguard deposits your cash with HSBC bank. So if Vanguard went down and your cash was stored with HSBC at the time then all is well – provided the bank remains standing. 

If HSBC defaulted then your Vanguard cash would be a risk. In that scenario, your ultimate backstop is the FSCS cash compensation limit of £85,000. But that claim would be set against your cash at HSBC, not Vanguard. 

Moreover, your £85,000 worth of protection is measured versus all the cash you’ve lodged at HSBC. 

So if you have a HSBC savings account worth £85,000, plus a Vanguard cash balance of £85,000, you’re still only covered by the FSCS for £85,000. Not £170,000. 

This rule applies across the board with the FSCS. The protection limit applies:

• Per authorised firm – including their sub brands
• Per person – so joint accounts are covered up to £170,000
• Per claim category – i.e. cash is one category and investments another. That means all your investment funds held with one institution are only covered up to £85,000

So to avoid breaching the FSCS ceiling you must only keep £85,000 total in cash at all HSBC related accounts, including Vanguard, First Direct, and any other brokers who deposit with HSBC. 

Obviously Vanguard could change its partner bank. But it says it’ll let account holders know in that event. 

Some brokers divide client money between multiple banks to diversify the risk of a default.

AJ Bell claims:

If we held 20%, or one fifth, of your cash with a bank that failed, up to £425,000 would be fully protected by the FSCS (i.e. 5 x £85,000).

Vanguard only mentions HSBC, though. 

Will Vanguard’s cash interest rate remain competitive?

Vanguard’s business is investing not banking. If it is flooded with cash from UK money mavens then I suspect we’ll find it dropping down the ‘savings account’ league table pretty quickly. 

But for now Vanguard’s cash interest rate is a welcome point of difference that’s much higher than rivals such as Interactive Investor, Fidelity and AJ Bell.

Enjoy it while it lasts. 

Take it steady,

The Accumulator