Bill Gross Analyzes the Conundrum

This is part of his conclusion about the strange times we live in.

In light of our rationale, which attempts to explain the great "conundrum," an interested reader might wonder why our durations and overall strategy appear so defensive. After all, if foreign central banks and others continue to absorb 70%+ of the bond market's new supply (900 billion out of an estimated 1.3 trillion in 2004), why wouldn't this "squeezing" out of domestic investors continue unabated, with yields continuing to move lower? The insensitivity to price/yield exhibited by Asian central banks in an effort to cap their own currencies might seem just as illogical 50 basis points lower as it does right now. And if the lack of global aggregate demand reflected in a surfeit of savings is really the primary cause, the malady is not likely to improve for years. Point granted. We might be at the mercy of a bond market tsunami here, whose first wave has struck and is now receding, only to be followed by more of the same in a few short months. This possibility is part of any interest rate guessing game except it is complicated in this new instance by buyers who have non-interest rate concerns. Still, there are limits. Why would a central bank buy 10-year Treasury paper below 4% if it expected 3-month Treasury Bills to be yielding 3 1/2% by the end of the year? It could cap its currency just as easily by going the short maturity route without risking future price losses. And for those institutional foreign bond holders, and the "hedgies" domiciled in the Caymans, there's no doubt too that a higher and higher short rate reduces and in some cases eliminates "carry," leading to collapsed positions and ultimately higher yields further out on the curve.

The interesting aspect was his wait and see approach. He knows how it will end but does not see when that end will arrive and is making sure he can out last the central banks. The system does not seem sustainable for long in my view but it is easy to see that surviving to pick up the pieces is a pretty attractive option.

His chart of U.S. debt outstanding against domestic ownership is just plain scary.