Pimco Betting Against Deflation, Really?

Pacific Investment Management Co. (Bill Gross) has made an $8.1B bet that the U.S. won’t suffer Japan's fate and suffer a decade of deflation.

Or so is what the media headlines scream today. The question is whether $8B can be considered a serious amount, given the $700B bailouts, the $1T backstops Europe, or that the US runs a deficit of a few Billions every day. $8B is really quite small.

Bloomberg says that Mihir Worah, head of Pimco’s real return portfolio management team, says that “We think the possibility that the U.S. goes 10 years with stagnant or falling prices is remote,” “The options were priced at rich levels to the underlying”.

"The cost of protecting against deflation has doubled since January as signs of an economic slowdown in the U.S. prompted investors including Canadian insurer Fairfax Financial Holdings Ltd. to buy the derivatives".

Pimco's Chief Executive Officer MOhamed El-Erian had said last month the chance of deflation in the U.S. was around 25%

"Pimco disclosed in a June filing that its funds began writing 10-year inflation floors during March and reported last month that they issued additional contracts in April. According to the Aug. 27 filing with the U.S. Securities and Exchange Commission, 25 Pimco funds entered into these inflation floors during this year’s first half, with Gross’s $247.9 billion Pimco Total Return fund accounting for $6.57 billion of the $8.1 billion tota'".

"In Pimco’s case, a cumulative 10 percent decline in the price index over 10 years would require the funds to pay out a total of about $810 million, based on that formula. The funds would pay nothing to the counterparties and keep the premiums if prices in 2020 are equal to or higher than in December 2009 or January 2010, depending on the contracts.
“This is obviously a very low-frequency, high-severity event,” Greenwood said. “Investors fear deflation, but most ascribe a low probability to it.”

"With U.S. unemployment stuck near 10 percent and consumer prices rising just 1.2 percent for the 12 months ended in July, investors have been seeking financial products that would protect their holdings from deflation. Canadian insurer Fairfax Financial Holdings said in July that it bought 10-year contracts tied to consumer price indexes with a face value of $21.5 billion in this year’s first half".