Mortgage rates may rise after failed gilt auction

The government's failure to sell all the available gilts at Wednesday's auction is worrying. We look at what it means for all of us - especially mortgage borrowers.

This week, the government attempted to raise £1.75 billion by selling gilts (or bonds) at one of its regular auctions. For the first time in seven years, the government wasn't able to sell all the gilts on offer - only 93% found buyers.

This is a worrying event for several reasons. Let's look at what it could mean for the likes of you and me.

1.       Fixed-rate mortgages will probably become more expensive

When a lender sets the rates for new fixed-rate mortgages, it looks at gilt yields. If the government is struggling to sell gilts, it has to cut the price of the gilts to find buyers.

Imagine a gilt is set to pay £1 a year to its owner. If you paid £100 for that gilt, you'd receive a 1% yield on your money. But if you paid £90 for the gilt, you'd receive a 1.11% yield. [The calculation is (1/90)*100.]

So as gilt prices fall, gilt yields rise. And as gilt yields rise, borrowing in the money markets becomes more expensive. So banks start charging higher rates on their loans to each other, and the rates for new fixed-rate mortgages rise as a result.

This week, mortgage guru Ray Boulger said he expects fixed-rate mortgages to start rising next week and I think he's probably right. So if you're thinking about taking out a fixed-rate mortgage, maybe you need to speed up.

That said, I'm not saying that everyone should suddenly take out a new fixed rate mortgage. If you've already got a great mortgage deal, you may be better off staying put. This is expecially true if you will be hit by early repayment charges if you try to remortgage right now. If you're unsure, check your mortgage contract or get some advice from a mortgage broker.

2.       The recession could last longer

The failed auction may mean that the government will struggle to finance its debt. If auctions fail repeatedly, the government might even have to go to the IMF and beg for cash as it did in the 70s.

But don't assume that will definitely happen. For starters, yesterday's auction was for 40-year gilts - investors will be happier to buy gilts that are for shorter periods. What's more, the government may be able to shift more gilts if it lowers the price and pays a higher yield.

But higher gilt yields will eventually push up the costs of all sorts of loans, not just fixed-rate mortgages, and higher loan rates will hamper economic recovery.

3.       No more tax cuts

It's pretty obvious that Gordon Brown had wanted to deliver a further 'fiscal stimulus' following last November's VAT cut. Such a stimulus would comprise further tax cuts or increased capital expenditure for things like roads or new schools.

I've written before that I'm a fan of stimulus packages in the current economic environment. Although it seems strange to cure a debt-fuelled crisis with more debt, I believe that this is the kind of recession where traditional Keynesian pump priming can be the right approach. For example, I think Barack Obama was right to push through a large US stimulus package in the last few weeks.

But sadly, there's one crucial difference between the situation in the UK and the US. The markets appear to be losing confidence in the UK's ability to repay its debt, and that's why the spectre of the IMF is looming. I'm pretty sure that the US will find it much easier to borrow at a reasonable price.

Given that background, it's clear that Brown will find it hard to introduce any further stimulus packages. That means no more tax cuts or big increases in capital programmes.

4.       Any grounds for optimism?

There was another gilts auction today (Thursday) and that was more successful. Gilts worth £1.1 billion were sold, and some bidders didn't get as many gilts as they wanted. The gilts were for shorter periods than 40 years.

I expect Alistair Darling smiled when he heard this news - as did I. It's encouraging but I still think mortgage rates will rise, and the government may still struggle to finance its debt over the next year or so.

So if you do want a competitive fixed rate mortgage, you might want to get your socks on....

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