Playing Both Sides against the Middle (Inflation vs Deflation)

Pimco Makes $8.1 Billion Bet Against ‘Lost Decade’ of Deflation
Sept. 15 (Bloomberg)
By Miles Weiss

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Excerpts

Devalue Dollar

As recently as April, Pimco’s Worah wrote that inflation, not deflation, was the primary long-term concern in the U.S., given that the federal government could choose to address widening budget deficits by devaluing the dollar. Scott Mather, Pimco’s head of global portfolio management, wrote in August that the odds had increased of the U.S. suffering a Japanese- style “lost decade.”

“If you have inflation going down toward zero, you enter a new regime where expectations can become a self-fulfilling prophecy,” Mather said in an interview. “That is what we saw in Japan as well,” he said, referring to an era of declining real estate and equity prices that began in the early 1990s.

While the derivative contracts suggest that deflation fears have increased, the risk of deflation in the U.S. is lower than it was in Japan because the two countries have different currency policies, said Donald Ratajczak, an economic consultant and former director of the Economic Forecasting Center at Georgia State University.

‘Bad Bet’

Japanese deflation stems from government policies to maintain the value of the yen that depleted the money supply there, said Ratajczak, who won acclaim from the Boston Federal Reserve Bank for his inflation forecast in the 1990s.

“We don’t care as much about our dollar,” said Ratajczak. “People who are betting on ten years of deflation are making a bad bet.”

Wall Street dealers write derivative contracts for clients that want to bet on or protect their holdings from changes in interest rates, commodities, stock prices and other financial markets. The dealers can then keep the contracts, sell some of them to other Wall Street firms through the inter-dealer market, or find counterparties such as Pimco that will take the other side of the trade.

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Buffett’s Model

Fairfax, based in Toronto, sells insurance and invests the premiums it receives in out-of-favor securities, similar to Buffett’s investment model. Equities are more at risk from deflation than fixed income securities such as the Treasury bonds Pimco holds in its funds, and which gain in value as interest rates decline.

Given the size of the inflation floors bought by Fairfax Financial, Pimco may have taken the other side on some of them, said Greenwood.

Paul Rivett, Fairfax Financial’s chief legal officer, declined to comment on the counterparties to the contracts.

“We are very concerned about deflation and have put this trade on to hedge some of what we see as a not insignificant risk,” Rivett said in an e-mail. “Unfortunately, we have not publicly disclosed the inner mechanics of the trade.”