PIMCO Scores on Inflation Bet

(July 6, 2011) – In a high profile episode of financial brinksmanship, Pacific Investment Management Co. (PIMCO) bested Morgan Stanley when they took opposing positions on inflation through the purchase of U.S. Treasury securities, the Wall Street Journal has reported.

PIMCO gained about $50 million by purchasing Treasury Inflation Protected Securities (TIPS) while Morgan Stanley lost tens of millions of dollars by shorting the bonds and making other related moves.

PIMCO began to purchase 30-year TIPS after the firm became convinced that long-term inflation was rising. Morgan Stanley, believing that investors were overstating the risk of long-term inflation and underestimating the potential for short-term inflation, began to short 30-year TIPS and purchased “nominal” 30-year Treasury securities unprotected from inflation. To capitalize on their assumption that short-term inflation would rise, Morgan Stanley also bought five-year inflation-protected bonds and shorted five-year unprotected bonds.

PIMCO became aware of Morgan Stanley’s position on inflation and vice versa. As Morgan Stanley began to offload more and more of the 30-year TIPS, PIMCO eagerly snatched them up. PIMCO’s action in turn helped Morgan Stanley add to its own short position.

As the price of 30-year TIPS rose and the prospect of short-term inflation receded, Morgan Stanley began to recognize that its bets on inflation had proven disobliging. At a June 23 auction for 30-year TIPS Morgan Stanley tried to back off from its position and purchase the bonds. PIMCO and others, seeing an opportunity, decided to bid heavily and made a record amount of bids in relation to auction size.

PIMCO and its head Bill Gross, though generally regarded as exceptionally skilled fixed income investors, have not been immune to missteps in the bond market. Gross took an aggressively short position against U.S. Treasury securities in April, saying that Treasuries “have little value within the context of a $75 trillion total debt burden.” Gross’ move proved ill-timed as it robbed PIMCO from receiving the fruits of a later Treasury rally.