Deflation hedges

kfh227 · February 18, 2015

Nico,

Thanks!

UPDATE: Local BAM! didn't have it so I just ordered via Amazon.

TwoCitiesCapital · February 19, 2015

http://www.bloomberg.com/news/articles/2015-01-30/euro-area-prices-extend-slide-in-sign-ecb-late-to-deflation-game

Even the U.S. is expected to see nominal, headline CPI deflation in 2015 - largely due to lower energy costs and how that flows through to most goods produced. Just as a quick summary of what we need to see for these to be profitable.

As of 9/30/2014
U.S. EUR UK FRANCE
Weighted Strike price 232.19 111.24 243.82 123.85
Nominal (in billions 52.75 36.775 3.3 2.75
Current CPI 238.03 117.43 257.6 124.85
Delta to breakeven -2.45% -5.27% -5.35% -0.80%

Deflation hedges pulled in 116.4M gain in the 4th quarter for a total of +17.7M for the year. This means that the swaps were literally up some 95% in fair market value just in the fourth quarter alone on the decline in oil. Many are expecting headline deflation in 2015 due to the slowing of economies and cheaper oil working it's way through the supply system - we don't need much to get us to breakeven on these swaps. 1-2 years of negative headline inflation in the CPI could result in a nice payday of a few hundred million.

As a reminder, every 1% beyond the 2.45% needed to breakeven in the US would result in a net gain of 527M. I wouldn't be surprised to see them continue building these positions though - they've expanded them aggressively over the past few years at prices more attractive than the original position was purchased at.

2010 - 34.2B in notional (cost 302M)
2011 - 46.5B in notional (cost 421M)
2012 - 48.4B in notional (cost 454M)
2013 - 82.9B in notional (cost 546M)
2014 - 111.8B in notional (cost 655.4M)

From the original position in 2010, Watsa has committed 116% more capital to increase the exposure by 226% AND adjust the strike price upwards. Averaging down seems to have worked out well. I'm thinking these might actually pay in the next year or two.

French consumer prices fall 1.1% MoM and 0.4% YoY. France is the country closest to inflation breakeven for Fairfax though it's only 2.75B in notional so it won't be a game changer.

ok22 · February 19, 2015

Zachmansell:

Your table, way of thinking about and tracking the CPI/Deflation investments made by FFH and updates are very helpful. Much appreciated.

Wondering where you are getting the data that allows you to track the CPI indices. I found the attached CPI Index data and am having trouble replicating the CPI numbers you are using. Biggest variance is for the UK numbers. What am I missing?

Is there a different CPI index that is the correct apples to apples comparison for the Fairfax deflation investments? As you know there are a bunch of variants for each CPI index (ex-energy, ex-pretty much anything you want to ex :)

Would love to keep track of the bets independently and would appreciate you directing me to the correct data source that applies to the specific FFH investment bets.

Thanks.

TwoCitiesCapital · February 20, 2015

Zachmansell:

Your table, way of thinking about and tracking the CPI/Deflation investments made by FFH and updates are very helpful. Much appreciated.

Wondering where you are getting the data that allows you to track the CPI indices. I found the attached CPI Index data and am having trouble replicating the CPI numbers you are using. Biggest variance is for the UK numbers. What am I missing?

Is there a different CPI index that is the correct apples to apples comparison for the Fairfax deflation investments? As you know there are a bunch of variants for each CPI index (ex-energy, ex-pretty much anything you want to ex :)

Would love to keep track of the bets independently and would appreciate you directing me to the correct data source that applies to the specific FFH investment bets.

Thanks.

All of the CPI data and related strikes come from Fairfax regular releases. I haven't ever tried to look up, or correlate the index myself, but I would assume they're using a different index or measure of consumer prices than what you're using if the figures don't align.

rb · February 20, 2015

Zachmansell:

Your table, way of thinking about and tracking the CPI/Deflation investments made by FFH and updates are very helpful. Much appreciated.

Wondering where you are getting the data that allows you to track the CPI indices. I found the attached CPI Index data and am having trouble replicating the CPI numbers you are using. Biggest variance is for the UK numbers. What am I missing?

Is there a different CPI index that is the correct apples to apples comparison for the Fairfax deflation investments? As you know there are a bunch of variants for each CPI index (ex-energy, ex-pretty much anything you want to ex :)

Would love to keep track of the bets independently and would appreciate you directing me to the correct data source that applies to the specific FFH investment bets.

Thanks.

All of the CPI data and related strikes come from Fairfax regular releases. I haven't ever tried to look up, or correlate the index myself, but I would assume they're using a different index or measure of consumer prices than what you're using if the figures don't align.

There are many way's to measure inflation. The Fairfax deflation investments are OTC derivatives. This means that they have to be based on a majour inflation index. But inflation can be measured in different ways, CPI, Core CPI, CPE Deflator, etc. My advice, if you want to find the right one is to go to FRED at St. Louis Fed, go to inflation and try each one until you hit the right one.

I know this may not be that much help, but short of FFH disclosing the terms of the derivatives is the most sure way to get to the right answer.

rb

twacowfca · February 24, 2015

http://www.bloomberg.com/news/articles/2015-01-30/euro-area-prices-extend-slide-in-sign-ecb-late-to-deflation-game

Even the U.S. is expected to see nominal, headline CPI deflation in 2015 - largely due to lower energy costs and how that flows through to most goods produced. Just as a quick summary of what we need to see for these to be profitable.

As of 9/30/2014
U.S. EUR UK FRANCE
Weighted Strike price 232.19 111.24 243.82 123.85
Nominal (in billions 52.75 36.775 3.3 2.75
Current CPI 238.03 117.43 257.6 124.85
Delta to breakeven -2.45% -5.27% -5.35% -0.80%

Deflation hedges pulled in 116.4M gain in the 4th quarter for a total of +17.7M for the year. This means that the swaps were literally up some 95% in fair market value just in the fourth quarter alone on the decline in oil. Many are expecting headline deflation in 2015 due to the slowing of economies and cheaper oil working it's way through the supply system - we don't need much to get us to breakeven on these swaps. 1-2 years of negative headline inflation in the CPI could result in a nice payday of a few hundred million.

As a reminder, every 1% beyond the 2.45% needed to breakeven in the US would result in a net gain of 527M. I wouldn't be surprised to see them continue building these positions though - they've expanded them aggressively over the past few years at prices more attractive than the original position was purchased at.

2010 - 34.2B in notional (cost 302M)
2011 - 46.5B in notional (cost 421M)
2012 - 48.4B in notional (cost 454M)
2013 - 82.9B in notional (cost 546M)
2014 - 111.8B in notional (cost 655.4M)

From the original position in 2010, Watsa has committed 116% more capital to increase the exposure by 226% AND adjust the strike price upwards. Averaging down seems to have worked out well. I'm thinking these might actually pay in the next year or two.

French consumer prices fall 1.1% MoM and 0.4% YoY. France is the country closest to inflation breakeven for Fairfax though it's only 2.75B in notional so it won't be a game changer.

Realize that Prem explained that these CPI type derivatives don 't have to actually be in the money to break even. They 're like options. When the underlying goes down, the implied volatility goes up, sometimes a lot!

TwoCitiesCapital · February 24, 2015

http://www.bloomberg.com/news/articles/2015-01-30/euro-area-prices-extend-slide-in-sign-ecb-late-to-deflation-game

Even the U.S. is expected to see nominal, headline CPI deflation in 2015 - largely due to lower energy costs and how that flows through to most goods produced. Just as a quick summary of what we need to see for these to be profitable.

As of 9/30/2014
U.S. EUR UK FRANCE
Weighted Strike price 232.19 111.24 243.82 123.85
Nominal (in billions 52.75 36.775 3.3 2.75
Current CPI 238.03 117.43 257.6 124.85
Delta to breakeven -2.45% -5.27% -5.35% -0.80%

Deflation hedges pulled in 116.4M gain in the 4th quarter for a total of +17.7M for the year. This means that the swaps were literally up some 95% in fair market value just in the fourth quarter alone on the decline in oil. Many are expecting headline deflation in 2015 due to the slowing of economies and cheaper oil working it's way through the supply system - we don't need much to get us to breakeven on these swaps. 1-2 years of negative headline inflation in the CPI could result in a nice payday of a few hundred million.

As a reminder, every 1% beyond the 2.45% needed to breakeven in the US would result in a net gain of 527M. I wouldn't be surprised to see them continue building these positions though - they've expanded them aggressively over the past few years at prices more attractive than the original position was purchased at.

2010 - 34.2B in notional (cost 302M)
2011 - 46.5B in notional (cost 421M)
2012 - 48.4B in notional (cost 454M)
2013 - 82.9B in notional (cost 546M)
2014 - 111.8B in notional (cost 655.4M)

From the original position in 2010, Watsa has committed 116% more capital to increase the exposure by 226% AND adjust the strike price upwards. Averaging down seems to have worked out well. I'm thinking these might actually pay in the next year or two.

French consumer prices fall 1.1% MoM and 0.4% YoY. France is the country closest to inflation breakeven for Fairfax though it's only 2.75B in notional so it won't be a game changer.

Realize that Prem explained that these CPI type derivatives don 't have to actually be in the money to break even. They 're like options. When the underlying goes down, the implied volatility goes up, sometimes a lot!

I totally agree, but I doubt Prem is going to sell them for a moderate gain simply due to time value and a vol premium. He has more than doubled the exposure since the bet was originally made and it's because he thinks there will be deflation. I imagine he will hold these for a few years more and the time value and volatility premium will vary over the course of that time (declining to zero for both if held to maturity). For this reason, I choose to ignore them and their variations and simply focus on how much money we'll make related to the direct pricing of the underlying because that what will drive 90% of the returns for us.

kevin4u2 · February 25, 2015

I was surprised that there was no discussion of the PPI numbers from last week. Tomorrows CPI numbers should be interesting. Attached are the some highlights from the PPI report.

TwoCitiesCapital · February 26, 2015

http://www.bloomberg.com/news/articles/2015-01-30/euro-area-prices-extend-slide-in-sign-ecb-late-to-deflation-game

Even the U.S. is expected to see nominal, headline CPI deflation in 2015 - largely due to lower energy costs and how that flows through to most goods produced. Just as a quick summary of what we need to see for these to be profitable.

As of 9/30/2014
U.S. EUR UK FRANCE
Weighted Strike price 232.19 111.24 243.82 123.85
Nominal (in billions 52.75 36.775 3.3 2.75
Current CPI 238.03 117.43 257.6 124.85
Delta to breakeven -2.45% -5.27% -5.35% -0.80%

Deflation hedges pulled in 116.4M gain in the 4th quarter for a total of +17.7M for the year. This means that the swaps were literally up some 95% in fair market value just in the fourth quarter alone on the decline in oil. Many are expecting headline deflation in 2015 due to the slowing of economies and cheaper oil working it's way through the supply system - we don't need much to get us to breakeven on these swaps. 1-2 years of negative headline inflation in the CPI could result in a nice payday of a few hundred million.

As a reminder, every 1% beyond the 2.45% needed to breakeven in the US would result in a net gain of 527M. I wouldn't be surprised to see them continue building these positions though - they've expanded them aggressively over the past few years at prices more attractive than the original position was purchased at.

2010 - 34.2B in notional (cost 302M)
2011 - 46.5B in notional (cost 421M)
2012 - 48.4B in notional (cost 454M)
2013 - 82.9B in notional (cost 546M)
2014 - 111.8B in notional (cost 655.4M)

From the original position in 2010, Watsa has committed 116% more capital to increase the exposure by 226% AND adjust the strike price upwards. Averaging down seems to have worked out well. I'm thinking these might actually pay in the next year or two.

French consumer prices fall 1.1% MoM and 0.4% YoY. France is the country closest to inflation breakeven for Fairfax though it's only 2.75B in notional so it won't be a game changer.

U.S. prices fall 0.7% MoM and 0.1% YoY

http://www.cnbc.com/id/102454987

obtuse_investor · February 26, 2015

U.S. prices fall 0.7% MoM and 0.1% YoY
http://www.cnbc.com/id/102454987

The leading indicator (http://bpp.mit.edu/usa/) seems to be indicating a -1% MoM and YoY. This will be interesting.

giofranchi · February 26, 2015

http://www.marketwatch.com/story/consumer-inflation-trend-turns-negative-for-first-time-since-2009-2015-02-26

Gio

ni-co · February 26, 2015

U.S. prices fall 0.7% MoM and 0.1% YoY
http://www.cnbc.com/id/102454987

The leading indicator (http://bpp.mit.edu/usa/) seems to be indicating a -1% MoM and YoY. This will be interesting.

Take a look at this, it's more current:

http://www.pricestats.com/us-series

kevin4u2 · February 26, 2015

http://money.cnn.com/2015/02/26/news/economy/inflation-january-negative/

We now have official confirmation, not from the BLS but from CNN.

May 3, 2015

I'm no expert when it comes to deflation but I don't understand why you would bet on it happening to a great extent. The definition of deflation is if prices drop, people will stop buying, as they will see that prices will be lower in the future and thus delay purchases. But do consumers think this way? No. Who here has ever delayed a purchase because they think prices will be cheaper tomorrow?

I never have. For example, if you're hungry and in a grocery store and want to buy a sandwich, would you say, I'm not buying this because it will be cheaper tomorrow? Nobody would do that.

People buy cars, washing machines, refrigerators, computers, iphones, clothing, shoes because their existing ones have worn out. They don't sit around like economists and make predictions about the prices of products. The avg. consumers has no idea where prices are trending.

Also, the world's population is still growing, so wouldn't there be more demand for products thus, increasing prices? Why would prices go down if the population is growing? Doesn't make much sense to me.

Just think about the computer business. How much did a computer cost in 1985? I don't have exact $ amounts in front of me but I would guess it was a few thousand. That computer was crap compared to a laptop today which you can buy for $500. A million times faster than the computer we all bought in 1985. Who in 1985 said, I'm not buying a computer for $2000 today, when I can wait until 1990 and buy one that is way faster and for half the price? Nobody does that because consumers don't think that way.

The PC market today is mature and prices are flat. How much lower can you go for a $500 laptop? Again, who here will delay purchasing a computer because I thought, well, if I wait another year, prices will be lower and the features will be better! Even though I know this would be the case.

Same thing with a video game system. I bought Nitendo, sega, playstation, and xbox growing up as a kid. Who here knows anybody that didn't buy a console because the next one would be cheaper and way better than the current system? Again. I know this is the case but it doesn't make me not purchase today's new console.

Maybe I'm wrong but betting on deflation happening to a great extent doesn't make much sense to me.

50cent

Jurgis · May 3, 2015

But do consumers think this way? No. Who here has ever delayed a purchase because they think prices will be cheaper tomorrow?
I never have.

Funny thing. :)

I mostly agree with you that people don't usually delay purchases because something will be cheaper tomorrow.

But of course you made a mistake asking these rhetorical (?) questions on CoBF. Cause this is the crowd that delays buying things because they will be cheaper tomorrow habitually. 8)

Yeah, I have delayed buying cars, computers, DVD players, etc. because they will be cheaper tomorrow and because of the time value of money. Many times.

But sure, we are not majority of consumers, so this is just a funny thing and it does not negate your thesis.

And, as I said, I mostly agree with you. However, there still could be deflation not because consumers wait for cheaper prices tomorrow, but because they can't buy today. That's the deflation of house prices in 2008-2009. People might have wanted to buy the house, but they couldn't and the prices dropped and dropped. So, yeah, there are situations where deflation is possible, but it's probably more likely in economic downturn. So, perhaps Europe...

mcliu · May 3, 2015

I think it may also be beneficial to think of deflation in the supply context. Even if demand is growing, if capacity and supply is growing at a faster rate, you will see deflation. That's sort of what we've been seeing, for example, in the global labour market (huge supply growth as a result of globalization) and Chinese manufacturing..

Zorrofan · May 4, 2015

I'm no expert when it comes to deflation but I don't understand why you would bet on it happening to a great extent. The definition of deflation is if prices drop, people will stop buying, as they will see that prices will be lower in the future and thus delay purchases. But do consumers think this way? No. Who here has ever delayed a purchase because they think prices will be cheaper tomorrow?
I never have. For example, if you're hungry and in a grocery store and want to buy a sandwich, would you say, I'm not buying this because it will be cheaper tomorrow? Nobody would do that.

People buy cars, washing machines, refrigerators, computers, iphones, clothing, shoes because their existing ones have worn out. They don't sit around like economists and make predictions about the prices of products. The avg. consumers has no idea where prices are trending.

Also, the world's population is still growing, so wouldn't there be more demand for products thus, increasing prices? Why would prices go down if the population is growing? Doesn't make much sense to me.

Just think about the computer business. How much did a computer cost in 1985? I don't have exact $ amounts in front of me but I would guess it was a few thousand. That computer was crap compared to a laptop today which you can buy for $500. A million times faster than the computer we all bought in 1985. Who in 1985 said, I'm not buying a computer for $2000 today, when I can wait until 1990 and buy one that is way faster and for half the price? Nobody does that because consumers don't think that way.

The PC market today is mature and prices are flat. How much lower can you go for a $500 laptop? Again, who here will delay purchasing a computer because I thought, well, if I wait another year, prices will be lower and the features will be better! Even though I know this would be the case.

Same thing with a video game system. I bought Nitendo, sega, playstation, and xbox growing up as a kid. Who here knows anybody that didn't buy a console because the next one would be cheaper and way better than the current system? Again. I know this is the case but it doesn't make me not purchase today's new console.

Maybe I'm wrong but betting on deflation happening to a great extent doesn't make much sense to me.

50cent

Take a look at Japan's 20 year struggle with deflation...people put off purchases all the time if they think something will be cheaper later. Food? no, of course not. But larger purchases yes....and Prem is betting that deflation will be a problem as well.

cheers

Zorro

cwericb · May 4, 2015

My experience with deflation primarily involves interest rates and the real estate and construction industries. I have seen mortgage rates run from around 8% up to 20% and back down to where they are now.

When interest rates were escalating quickly, people were in a hurry to buy or build before the rates went higher. When interest rates began to drop sharply, people would tend to put off major purchases waiting to get a better rate. It was primarily the periods where rates would temporarily stabilize that people would make their decisions.

From this experience, my take would be that if prices start to deflate people will tend to delay major purchases waiting for better prices or for prices to stabilize.

Of course this doesn’t apply to items like food, but it does apply to things like clothing, household appliances, vehicles, etc because people will try to get just a little more use out of what they have today before they buy.

To suggest that people do not wait for lower prices really doesn’t make much sense. How many people will wait for something to go on sale before they buy? Of course there is a certain segment of the population that is wealthy enough that they don’t have to wait - but even those people may say, well if that yacht looks like it may drop from twenty million to fifteen million if they wait a few months, well....

giofranchi · June 30, 2015

Eurozone inflation eases, reviving deflation fears

http://www.marketwatch.com/story/eurozone-inflation-eases-reviving-deflation-fears-2015-06-30?link=MW_home_latest_news

Gio

dartmonkey · July 3, 2015

I'm no expert when it comes to deflation but I don't understand why you would bet on it happening to a great extent. The definition of deflation is if prices drop, people will stop buying, as they will see that prices will be lower in the future and thus delay purchases. But do consumers think this way? No. Who here has ever delayed a purchase because they think prices will be cheaper tomorrow?
I never have. For example, if you're hungry and in a grocery store and want to buy a sandwich, would you say, I'm not buying this because it will be cheaper tomorrow? Nobody would do that.

People buy cars, washing machines, refrigerators, computers, iphones, clothing, shoes because their existing ones have worn out. They don't sit around like economists and make predictions about the prices of products.

50cent

Maybe you should wait and see how you feel as a consumer when you have actually experienced deflation, instead of basing your opinion on how consumers behave when their whole life has been in times of inflation.

TwoCitiesCapital · July 6, 2015

I'm no expert when it comes to deflation but I don't understand why you would bet on it happening to a great extent. The definition of deflation is if prices drop, people will stop buying, as they will see that prices will be lower in the future and thus delay purchases. But do consumers think this way? No. Who here has ever delayed a purchase because they think prices will be cheaper tomorrow?
I never have. For example, if you're hungry and in a grocery store and want to buy a sandwich, would you say, I'm not buying this because it will be cheaper tomorrow? Nobody would do that.

People buy cars, washing machines, refrigerators, computers, iphones, clothing, shoes because their existing ones have worn out. They don't sit around like economists and make predictions about the prices of products.

50cent

Maybe you should wait and see how you feel as a consumer when you have actually experienced deflation, instead of basing your opinion on how consumers behave when their whole life has been in times of inflation.

I'm sure this happens in some respect, but you can look at industries that have constant deflation to get an idea of consumer behavior. Look at electronics - we all know that the brand new flat screen TV will be cheaper in a few months and significantly cheaper when the next model comes out. Some people buy it right when it's released, others wait a few months, and others wait until the next model comes out to pick this one up on the cheap - but what doesn't happen is an entire stall in the market where nobody buys a TV simply because prices keep dropping. It takes a few months, but eventually, everyone who wanted a TV gets one at a price they were willing to pay.

I don't understand why this is worse than engineering false demand to buy something just because you think the price will go up in the future. Inflation and deflation bring with them both positive and negatives, but I don't think moderate deflation is anything of more concern than moderate inflation. It's only when you get to the extremes in either direction that you have a problem.

Luckyone77 · July 6, 2015

Eurozone inflation eases, reviving deflation fears

http://www.marketwatch.com/story/eurozone-inflation-eases-reviving-deflation-fears-2015-06-30?link=MW_home_latest_news

Gio

Wouldn't deflation have to be "significant" for all these bets to pay off in a meaningful way?

TwoCitiesCapital · July 6, 2015

Eurozone inflation eases, reviving deflation fears

http://www.marketwatch.com/story/eurozone-inflation-eases-reviving-deflation-fears-2015-06-30?link=MW_home_latest_news

Gio

Wouldn't deflation have to be "significant" for all these bets to pay off in a meaningful way? U.S. CPI is currently at 202

I think that depends on your view of what "meaningful" is. The current U.S. CPI index is in the mid-230s. It would take deflation of less than 2.5% over the next 8 years for us to break even on this position. Every % point beyond 2.5% nets $588M. Not an insignificant sum!

European figures are around 118. We need European deflation of about 6% over the next few years to breakeven. Every % past 6% nets $445M.

You can peg whatever likelihood on deflation that you want, but considering the last two prolonged deflationary episodes of developed economies lasted over a decade with cumulative deflation figures well above 2.5% and 6%, then I don't consider the current positioning to be too bad if you think that deflation has a possibility of occurring. Also, Prem has previously purchased more contracts, extended maturities, and lowered strike prices - if that trend continues, we stand to make more money (increasing notional) and increase the chances of making it (by extending duration and increasing strikes) if he is right.

valuesource · July 7, 2015

Good summary TwoCities,

I believe these contracts have about 7 yrs left on them. It's important to reiterate this 2.5% is cumulative deflation. Some of the contracts strike at 1% meaning cumulative deflation of less than 1% over 7 yrs is profitable.

-value

dartmonkey · July 7, 2015

Eurozone inflation eases, reviving deflation fears

http://www.marketwatch.com/story/eurozone-inflation-eases-reviving-deflation-fears-2015-06-30?link=MW_home_latest_news

Gio

Wouldn't deflation have to be "significant" for all these bets to pay off in a meaningful way? U.S. CPI is currently at 202

I think that depends on your view of what "meaningful" is. The current U.S. CPI index is in the mid-230s. It would take deflation of less than 2.5% over the next 8 years for us to break even on this position. Every % point beyond 2.5% nets $588M. Not an insignificant sum!

European figures are around 118. We need European deflation of about 6% over the next few years to breakeven. Every % past 6% nets $445M.

The 2015Q1 report says that US notional $46.2B has a weighted avg strike price of 231.32, and the index was at 236.12 on March 31st, so gains start with only a 2.0% drop in the index. Another $12.6B notional has a floor rate of 0.5% per annum, and a strike price of 238.30, with the index then at 236.12, so they are only 0.9% out of the money, and they make money if inflation is less than 0.5% beyond that strike price.

The other big chunk is on European inflation, with $39.5B notional at a strike price of 111.52, with the index now at 117.20, so in that case, we are 4.8% out of the money, meaning that we really would need a significant deflation before that part starts paying off.

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