Watsa, whose Canadian insurance firm made billions betting against the U.S. housing market and its chief lenders several years ago, is now buying derivative contracts that wager on a decline in the consumer-price index, which tracks inflation.
The derivatives that Fairfax bought earlier this year would now cost $330 million as more people worry about deflation, the WSJ reports, meaning the firm’s paper profit is already more than $150 million.
Paul Rivett, chief operating officer for Fairfax’s investing department, told the WSJ’s Gregory Zuckerman (who authored the book “The Greatest Trade Ever” about John Paulson’s huge bet against the housing market) that deflation will result from U.S. households borrowing less and saving more. He says the trend has only just begun and sees a double-dip recession as a real possibility.
Fairfax’s bet will pay off if inflation stays below 2 percent annually, which is the level at which the firm bought the contracts. It’s now running at about 1 percent.
It’s worth noting that Fairfax bought the contracts partly as a hedge against its $22 billion investment portfolio. Deflation is terrible for stock returns (though good for bonds), so the bet protects the overall return of Fairfax’s investments, which include many of the same stocks held by Warren Buffett’s Berkshire Hathaway.
Recently investors have been rushing into bonds, showing that Watsa isn’t the only investor who thinks deflation will be a problem. But there are plenty of people who disagree.
Buffett publicly has warned more about the risks of inflation due to the government’s massive debts and loose monetary policy. He's also reportedly been shortening the duration on Berkshire's bond portfolio, a move that would protect the firm in the event of interest rate increases. Many have argued that bonds are in a bubble now due to the number of investors fleeing stocks for their perceived safety.
Interestingly, on the same page as the Fairfax article, the WSJ ran a piece this morning saying that the U.S. money supply has risen every week since May 3. Federal Reserve chief Ben Bernanke has been dubbed “Helicopter Ben” for his hyper-awareness of Japanese-style deflation and his willingness to pour resources from above to prevent it.
If Watsa is wrong about deflation, his firm will lose the money it spent on the derivative contracts and its other investments will likely rise. If he’s right, the bet could be worth billions for Fairfax and would further enhance his already sterling reputation.
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