The headline says it all: "Mortgage Markets Are Out of Control." So Morgenson must believe that other markets are in control. Who controls them? Who controls the stock market, or the pork belly futures market -- are any other market? What is so wonderful about markets is precisely that everyone controls them -- and yet no one does. That seeming self-organizing quality of markets is what makes them so effective in price discovery and resource allocation -- and what makes them so threatening to elitists like Morgenson, who believe that everything of importance should be under state control (with the state to be controlled by people like... them).

The essence of Morgenson's column is that interest rates are now being determined by the mortgage-back security market, which is now the single largest sector of the US bond market. She explicitly dismisses the idea that interest rates are determined by economic growth expectations. That, she says, is only believed by "folks wearing the rose-colored shades" -- as though the whole idea that economic growth could possibly be accelerating is simply a delusion.

No, what determines interest rates "is a force so large and brutish that it could propel rates higher and faster than many investors expect: the huge mortgage-backed securities market and the leveraged traders who call it home."

How is that supposed to happen? Morgenson explains that mortgage-backed securities traders hedge their holdings "by selling short Treasury securities with maturities roughly equal to the average life of the mortgages in their portfolio." She explains -- quite approximately -- how when mortgage rates rise and fall, the average life to be hedged changes (bond experts call that effect "convexity"), driving the need to adjust the Treasury hedge. When mortgage rates fall, hedgers must buy Treasuries (because, presumably, these brutish people find themselves short -- how very Hobbesian); when they rise, hedgers must sell them. That, she claims, produces "a snowball effect that can push rates far lower or higher, and faster, than in previous years."

Okay, there's nothing basically wrong with that explanation of increased Treasury volatility. Although my friend Jameson Campaigne noted in an email to me that much the same point was made last week in much the same language in the August 2003 Whitebox Market Observer -- oh, surely a coincidence! A Pulitzer Prize winner like Morgenson would never plagiarize from a publication affiliated with her old boss Steve Forbes...

Be that as it may, to the extent that the fixed income market has become increasing populated by high-convexity securities, there will be some spill-over to lower-convexity securities, insofar as all markets are linked. This is entirely natural and basically harmless (and probably averages out over time). If there are some market participants who would rather that Treasury yields not be so volatile as a result of this effect (or any other), well... there are many nice things that one can wish for, but the fact that one must wish does not mean that there is anything wrong in the world. It just means one must do something to earn one's wish -- other than kvetching.

And none of this says anything about what determines interest rates. However mortgage rates and Treasury rates are determined, neither of them are interest rates per se -- they are both nothing more than the yields of particular securities that reflect interest rates (just as stocks, and -- to differing extents -- everything else in the economy reflects interest rates). Interest rates are an abstraction. They are, by definition, the opportunity cost of money across time -- and opportunity cost is a function, mostly, of expected growth rates and expected inflation.

Thus Morgenson's explanation of rates being determined by mortgage trading is left looking very much like that so-called "proof" of the existence of God holds him to be the "prime cause." One can ask, "what caused God?" If moves in mortgage rates are the prime cause of interest rates, one can ask what moved mortgage rates? The answer is -- expected growth rates and expected inflation. Opportunity costs.

Morgenson inadvertently confesses as much, in a paragraph that she must not realize contradicts her entire thesis. Immediately after explaining how mortgage traders "helped push interest rates down to ridiculous levels earlier this year" and then later made "interest rates spike," Morgenson states,

"Last week, the Federal Reserve rattled the bond market by promising to keep rates low for as long as possible. Traders feared that the accommodative stance could be inflationary. They sold Treasuries, and rates rose."

Huh? First she says that the violent move in rates are caused "mortgage-backed securities market and the leveraged traders who call it home." Then, without taking a breath, she cites an explanation that has nothing to do with the mortgage market whatsoever. I have no idea (and either does Morgenson) what, if anything, "traders feared" last week. But at least this explanation gets to one of the true definitional drivers of interest rate changes -- inflationary expectations. Such expectations move mortgage markets and  Treasury markets (and those two markets move each other, too, as all markets move each other to some extent).

Having described -- and contradicted -- a problem that is not a problem, Morgenson looks for a scapegoat. And so the inevitable conclusion to a Gretchen Morgenson column -- the pointing finger, and the dire warning:

"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."

Why not say just the reverse? It works too: "these traders drove down rates, impoverishing investors, savers, retirees and companies invested in money market funds. Now, it is higher income -- and all its delightful implications -- for which everyone must prepare." Why didn't she include that perspective? Because the conspiracy to keep you poor and stupid requires that think of the market as a terrifying place where you are a likely victim of people who deliberately "create such havoc." When you think that, you'll want to be protected. And there is no shortage of politicians and regulators -- and the journalists who pimp for them -- who are only too happy to protect you... right into poverty.

Correction [8/18/2003]... Due to a simple typographical error of the kind that cannot be caught by spellchecking, as originally posted, I wrote that the mortgage backed securities market "is not the single largest sector of the US bond market." The word not should have been now. Thanks to Robert Musil of the Man Without Qualities blog for pointing this out.

Posted by Donald L. Luskin at 1:40 AM | link