Pimco makes $8.1-billion bet against 'lost decade' of deflation

Bill Gross’s Pacific Investment Management Co made an $8.1 billion wager that the US won’t suffer a decade of deflation like the one that crippled Japan starting in the 1990s.

That’s the notional value of long-term derivative contracts tied to the US consumer price index that Pimco’s mutual funds entered into during the first half of this year, according to a regulatory filing. The funds received $70.5 million in up-front premiums under these contracts, known as inflation floors, in return for agreeing to pay investors should prices decline in the 10 years ending in 2020.

“We think the possibility that the US goes 10 years with stagnant or falling prices is remote,” Mihir Worah, the head of Pimco’s real return portfolio management team, said in an e- mailed response to questions. “The options were priced at rich levels to the underlying” risk, added Worah, whose funds invest in Treasury inflation protected securities.

The cost of protecting against deflation has doubled since January as signs of an economic slowdown in the US prompted investors including Canadian insurer Fairfax Financial Holdings Ltd to buy the derivatives. James Bullard, president of the Federal Reserve Bank of St Louis, said the US could suffer the same type of economic malaise as Japan. Pimco Chief Executive Officer Mohamed El-Erian said last month the chance of deflation in the US is around 25 per cent.

‘New normal’
El-Erian has been among the most outspoken proponents of a theory forecasting years of below-average economic growth, elevated unemployment and a decreasing dominance of the US in the global economy. While falling prices are not his main scenario in that outlook, named “new normal,” El-Erian has argued that increased fear of deflation may have been one reason for recent sell-offs in financial markets such as the 2.8 per cent decline in the Standard & Poor’s 500 on August 11.

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 August 27 filing with the US 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 total.

Premiums from the contracts help boost fund income as yields on government bonds are near record lows. Potential losses are limited because the fixed-income securities that account for a majority of the $1.1 trillion the Newport Beach, California, firm oversees would probably gain in value if consumer prices had a protracted decline.