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PIMCO's gain will be Fairfax's loss - or vice versa.

Bill Gross's decision to cut the PIMCO Total Return Fund's U.S. government debt holdings to nil pits his investment thesis directly against that of Fairfax Financial chief executive Prem Watsa. (For more on PIMCO's decision see Bond market shrugs off PIMCO ditching U.S. government debt )

Fairfax, which is concerned that deflation could rear its head, is long U.S. treasuries in a big way. And it says it's sticking to its strategy.

The insurer's investment portfolio held U.S. treasuries with a carrying value of $2.46-billion (U.S.) at the end of December, up from $461-million in 2009. Fairfax also held $235-million at the holding company level, up from none in 2009.

As credit spreads came down last year Fairfax sold many corporate and distressed bonds at a profit, and bought government bonds. It's kept up that strategy in the early part of this year.

Mr. Watsa outlined his rationale in a letter to shareholders last week.

He's the first to acknowledge that the company's bearish outlook cost the company last year. Fairfax's decision to ramp up its equity hedging as high as it could go this past summer, to 100 per cent of its stocks, cost $936.6-million during the year.

But he sticks to his thesis that there is simply too much debt in the world. Mr. Watsa thinks that the end result of all the leverage in the system could be a period in which nominal economic growth remains flat for a decade or two with multiple bouts of deflation.

"We see many problems in Europe as country after country reduces government spending and increases taxes to help reduce fiscal deficits," Mr. Watsa wrote to shareholders. "We see the U.S. government embarking on a similar exercise (as it has no other option) and all this while businesses and individuals are deleveraging from their huge debts incurred prior to 2008."

With that thesis in mind, Brian Bradstreet - the investment brain at Fairfax who came up with its winning bet on credit default swaps prior to the crisis - is now betting on CPI-linked derivate contracts. The ten year contracts will make money in a deflationary environment, and become more profitable the higher the degree of deflation. By December Fairfax had invested $302.3-million in these contracts.

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