Central bankers vs. Bill Gross

May 20, 2011: 1:28 PM ET

Do central bankers have it in for the world's most widely cited Treasury bond bear?

You might well ask after reading the latest report from the rates strategists at Bank of America Merrill Lynch. They contend that global central bankers are about to spring off the sidelines to buy Treasury debt, in what stands to be the latest setback for the Pimco bond fund manager's giant bet against U.S. government bonds.

10-year yields: more of the same?

Since the Fed's latest round of bond buying started last November, BofA says, cash -- mostly in the form of dollars -- has been piling up in places like Brazil and India as money rushes toward faster-growing economies, in the form of trade surpluses as well as Fed-fueled capital inflows.

But in a familiar refrain, the bankers getting deluged by this money torrent have been sitting on their hands. Foreign exchange reserves held as bank deposits recently hit their highest level since the collapse of Lehman Brothers, BofA says, while the ratio of securities held for each unit of bank deposits has been dropping back to its post-panic low. What's more, the pace of foreign official Treasury accumulation slowed sharply in the fourth quarter.

There is, in short, a good deal of pent-up demand for Treasury bonds -- which is why BofA strategist Priya Misra sees solid support for the U.S. government bond market even after the Fed kicks its $75 billion-a-month habit.

"We believe the most likely explanation is that some reserve managers are awaiting the end of QE to put cash to work in the Treasury market, perhaps driven by the belief that rates are being kept artificially low by the Fed's steady buying," writes Misra.

The fog of foreign reserve data means that it's impossible to say for sure what is going on with the central bankers. That goes particularly for the mandarins perched atop the elephant in this room, China (which controls a third of the world's $9.2 trillion in foreign exchange reserves).

Even so, there are some clear signs that the Fed's decision to support the U.S. economy with a flood of dollar liquidity caused some behavioral changes among the globe's other dollar accumulators, from Indonesia and Poland to Japan and Russia.

"Beginning in November 2010 some of these central banks began to put a sizable amount of new cash into deposits at official institutions such as the Bank for International Settlements (BIS) and, to a lesser extent, at commercial banks," Misra writes. "Note that this marks the first sustained increase in deposits since the onset of the financial crisis."

Of course, as much as you might like your friendly local banker at the Bank of International Settlements, no one likes collecting 0.1% annually at a time when inflation is on the march. That's why BofA expects foreign reserve managers to start marching back into the Treasury market -- particularly in two-to-seven-year notes, all of which are being auctioned next week.

Demand for Treasury debt has been picking up anyway, thanks to slowdown signs in the U.S. economy and the fear that Europe's debt crisis is about to spiral out of control again. But unless Congress goes through with its threat to blow up the country in a stupid fight over the debt ceiling, lower Treasury yields look like a pretty good bet for the rest of 2011.

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