Since interest rates began surging in the United States a few weeks back, the folks wearing the rose-colored shades have said the climb is proof that an economic recovery is nigh. But there issomething more than a nascent rebound driving rates today. It is a force so large and brutish that it could propel rates higher and faster than many investors expect. The force in question is thehuge mortgage-backed securities market and the leveraged traders who call it home. Although many investors think that the Treasury market sets mortgage rates, mortgage-backed traders are the ones whohold sway. Their hegemony is a function of two things: the runaway growth in the mortgage market and the way mortgage portfolio managers must respond when rates rise or fall. Until 2000, the U.S.Treasury market was the world’s largest and most liquid. Now the government bond market is overshadowed by the mortgage-backed securities market. Treasury securities and corporate bonds each accountfor about 22 percent of the Lehman Brothers United States aggregate index, a measure of the whole fixed-income market; mortgage-backed securities make up almost 35 percent. This would not be aproblem if mortgage traders and managers of big loan portfolios, like Fannie Mae, did not typically hedge their holdings with Treasuries. Holders of mortgages hedge by short-selling Treasurysecurities with maturities roughly equal to the average life of the mortgages in their portfolio. Now, the hedgers’ needs can swamp the market they tap. This exacerbates moves in interest rates,producing a snowball effect that can push rates far lower or higher and faster than in previous years. Mortgage-backed securities respond violently to moves in interest rates. When rates fall andhomeowners refinance, some of the mortgages in large portfolios held by banks, hedge funds and mortgage originators are cashed in. That requires the managers of these portfolios to rebalance theirhedges by buying Treasury issues. Such buying helped push interest rates down to ridiculously low levels earlier this year. When rates rise, refinancings drop, and the average life of a mortgagegrows. That causes traders to rebalance portfolios by selling Treasuries. Selling begets selling; interest rates spike. Last week, the Federal Reserve rattled the bond market by promising to keeprates low for as long as possible. Traders feared that the accommodative stance could be inflationary. They sold Treasuries, and rates rose. James Bianco of Bianco Research in Chicago pointed outthat the last time interest rates moved up in the mid-1990s the mortgage-backed securities market was much smaller and more manageable. Back in 1996, the mortgage market was roughly half the size ofthe Treasury market, he said. Now it is 125 percent of the Treasury market.

Bianco fears that the size of the market and the fact that so many players are heavily leveraged make a disaster almost inevitable. If you look at the last 15 years of bond market derivative debacles, a lot of them involved mortgages, he said. These things have killed more people than any other trade.

The people running big mortgage portfolios would tell you that hedging allows them to manage away their risks. Bianco argues that the extreme volatility in the market suggests that the players have not properly managed their risks. We wouldn’t see these wild undulations in interest rates if they had already been hedged, he said. It is unfortunate that the problems of mortgage traders can create such havoc. But these traders drove down rates, benefiting consumers, companies and bondholders. Now, it is higher borrowing costs and their grimmer implications for which everyone must prepare.