Watsa and Gross face off over U.S. deflation

Two of North America's biggest money managers are positioning themselves on opposite sides of a multibillion-dollar fence on the question of U.S. deflation.

On one side is Canadian investing giant Prem Watsa, whose Fairfax Financial Holdings Ltd. has loaded up on $21.5-billion (U.S.) notional value of U.S. inflation floors - an over-the-counter derivative product that pays its holder the difference if consumer price index inflation slips below a certain level, effectively acting as insurance against disinflation or deflation. The amount roughly coincides with Fairfax's total investment assets under management.

On the other side is U.S. bond king Bill Gross, whose Pacific Investment Management Co. LLC (PIMCO) has sold $8.1-billion of inflation floors over the past six months, according to a regulatory filing reported by Bloomberg News - effectively assuming the other side of the deflation bet.

According to the Bloomberg report, PIMCO has made $70.5-million in premiums by selling the inflation floors. Fairfax reported that it spent $174-million acquiring the derivatives in the first half of the year - though that's a bargain, as growing deflation fears over the summer mean those same contracts would cost more than $300-million today.

Both the derivatives Fairfax purchased and those that PIMCO sold were believed to be 10-year contracts based on a CPI inflation level of 2 per cent. Buyers pay premiums to purchase the derivatives, and the sellers only pay out if the inflation rate over the entire 10 years averages less than 2 per cent annually. If, say, the inflation rate averaged zero per cent on a $10-billion contract, the payout would be the difference of 2 per cent on the notional value of the contract, or $200-million.

"The team has been every concerned about deflation," said Fairfax chief legal officer Paul Rivett, adding that history has shown that virtually every asset class is hurt in a deflationary environment. "Nobody wants it to happen, but it has been identified as a risk. We can't just ignore that."

For PIMCO, however, taking on what is essentially a bet against deflation looks odd at first glance. Mr. Gross and his colleagues have been vocal in their concern about the risk of deflation.

PIMCO officials weren't available for comment Wednesday.

In an interview with The Globe and Mail last month, Mr. Gross expressed concern about deflation, noting the U.S. inflation rate over the past two years was already close to zero. "We're certainly at risk of enduring a zero-to-1-per-cent number for the next 12 months at least," he said.

Also last month, PIMCO head of global portfolio management Scott Mather published a commentary warning the risk of a Japanese-style multi-year deflationary funk in the United States was rising, not falling.

Nevertheless, Mr. Mather said "the opposite could occur" - that rock-bottom interest rates and a surge in consumer demand could trigger a U.S. inflationary problem. "PIMCO is also incorporating this possibility in the set of long-term scenarios," he wrote.