jonathan: from new york city, i am jonathan ferro. with 30 minutes dedicated to the fixed income. this is "bloomberg real yield." ♪ jonathan: coming up, valuations remain elevated, volatility sinks. the epicenter of the reflation trade comes unstuck and china's deleveraging campaign rocks commodities. where are the investors who turned bullish? we start with a big issue. is low volatility a sign of investor complacency? >> you see that in equities, in credit, in interest rates,

really across the board, markets are looking past almost all risks out there. >> the vix is very low and you have got no real sense the markets are starting to crack. if the fed pushes their luck and hikes too much or tightens too fast, i think that will change. >> you are going to need to see clear evidence of inflation pressures building in order to quicken the pace of central banking tightening. i happen to believe that is a real possibility on the back end of this year. right now, i think the vix has it about right. >> are going to be that calm, if markets you need to leverage your positions. the more you leverage your positions the more they are , calm. the problem with that is you will get to a tipping point at some stage. jonathan: joining me from pennsylvania is greg davis. the global head of fixed-income at vanguard group. also, oksana aronov. alternative fixed-income strategist at j.p. morgan asset management. and the head of u.s. investment

credit at black rock. great to have you with me. the theme of the week has been low volatility, not just in the equity market, but across assets and the bond market and in fx as well. greg, my question to you with that chart in mind is whether you reconcile low volatility with complacency. do the two things equal? greg: i think there is a bit of both. when you are looking at what is driving some of this, you have a very accommodative monetary policy still in place and the -- in the u.s. and abroad, and that is helping to contribute to this low vol environment we have been seeing. there has also been a lot of expectations around what is going to happen in terms of growth in the economy given regulatory reform, fiscal reform, and things of that nature. i think all of those factors are helping to contribute to this low volatility environment we see on the equity side, the fixed income side, from treasury as well as spread product. oksana: i think when we talk about complacency and the fact

that volatility has been low, it is not just a week story. it is not this week's story, it is across markets and it is really outstanding. -- really astounding. there is perhaps no more overvalued and synthetically or absolutely not realistically priced market out there than the bond market with $30 trillion of stimulus. and we saw $200 billion pour into the market last year and it keeps on going unabated. it is not clear to me how or what investors are expecting to get, especially those getting exposure tracking the ag index, which is at a record duration high. what are the expectations? it is unclear to me. jonathan: the question i have asked on this program a couple of times, are you being adequately compensated for the risk you are assuming? just as a fundamental question, looking at fixed income, are you? >> i think you can make the argument that since volatility is so low, the compensation in

terms of the spread per unit the -- per unit of volatility is actually pretty high historically, but i think it is hard to argue that there is a lot of absolute value. oksana: if we saw a rates move back up to 2010 levels, we would see something like 6% to 8% losses in traditional bond market portfolios, especially considering that most of those on the individual investor sides are through mutual bonds. they are not maturing portfolios. i don't think there is enough realization out there that this is the risk that if you do see that move over a year's period of time, which is not unconscionable, to move back to a 3% ten year, those are have to losses you are looking at. jonathan: greg, let's get into that. what is the motivation to get exposure to the benchmark? what is the investment thesis behind it? greg: for most i think it is broad-based diversification at a

low cost. it is points well made in terms of valuations don't look attractive, but from a diversification benefit, bonds still make sense for most investors. if you go back and look at what during the worst months in the equity markets, bonds have been the place to be, in terms of having diversification or balance in the portfolio. it is nice high dividend. it is high-quality treasuries in corporate bonds that help you provide balance and diversification during the downturn in the equity market. i think that is what investors are gravitating towards. oksana: that is definitely true. one of the issues with taking historical analysis is that history tells us bonds historically have not been at 2% 10-year, but even 3% plus. yes, they were effective ballast. today, that is no longer the case.

you basically would come out even and while the equity market still has the same amount of downside potential, the fixed income market does not have the same side of upside potential. jeff: i do not disagree in terms of you are not getting compensated tremendously well. rates are very low and the potential for investor losses is certainly there. however, i think you also have to think about the probability of those scenarios occurring. and i think you will probably be in this range until you get one the few things to occur. i think some of those things are to the upside and downside. to the upside standpoint, i think you would really need to see for a yield to go up a lot, you need to see either true comprehensive tax reform happen, or i think you would need to see central-bank policy action that is in excess of what is already

priced in. to the downside, i think the two big risks are well we were talking about before. does the cyclical impulse from china start to dissipate? jonathan: over the last month what have we seen? we have seen softer data out of china. what is remarkable to me and many other people is the only asset class really adjusted to the data change out of china. it is commodities. why? oksana: i am looking at a chart here that shows china's housing market essentially turning over somewhat. and this has been the big reflation story china has gone through, this credit creation and the effect it had on the housing market. and that fed into em strength in general. em is another area that received sovereign type bonds and tremendous amount of interest. already more than all of 2016.

and yet, we have not seen a significantly stronger dollar this year, not significantly higher rates this year at all. there is this rhetoric out there to try and explain all of this euphoric inflows with em is resilient. there is the em is resilient. we haven't really seen the conditions that would warrant us to say that the em is resilient. last year was really an oil recovery story and this year we haven't really seen the type of environment that tests the em. perhaps we are starting to in china little bit, but i think generally the expectation is that china will be dormant until the national conference in the fall. jonathan: greg davis, is em resilient? greg: we think the fundamentals in em still look pretty attractive. when you look at valuations, though, we are not from a place where we feel like em with the place to be relative to the broader market. from a fundamental standpoint, we think em could continue to hold in for some time at least given what we are seeing. oksana: since i seem to be the

contrarian here today, em is at its tightest five-year level right now. and about maybe 100 basis points wider than the all-time high. this is hardly a valuation. i am not saying there are no pockets in em that may look good because fundamentals very, -- vary, but i think the exception would be the overwhelming sort of euphoric inflows and i question how much do the investors understand what they are buying and ultimately when levi em, we by china. em, we by china. jonathan: china has not rolled over em. why? oksana: it is going to take some time. jonathan: greg, help me out here, why? greg: em at the end of the day

is still a higher yield asset class. i think until you see things -- something fundamentally change in that space, you are going to continue to see investors flocking after higher-yielding products and that is driving some of the flows we see into the em complex. oksana: here is an interesting point, too, there is certainly a global surge for yield and it seems to be a huge benefit for em. yet we have another asset class, high yield bonds, which are not getting the love em is getting, even though there are pockets of that market offering significantly better compensation even on a default adjusted basis and anything around default and restructuring is a very well-delineated process where you know exactly what to expect. jonathan: where in high-yield would you be buying right now? oksana: to echo earlier comments, it is hard to argue for bargains within this market. within high-yield, there are pockets in the lower- rated part of the market, even the triple c part of the market which is

roughly 400 basis points above the all-time tights, and defaults have been roughly 4%. but you can double that number and you are still on a default adjusted basis getting paid. and i think there is this narrative generally of confusing quality with safety, whereas safety should be defined by your margin of safety, by your coupon cushion. and from that perspective, you are definitely being compensated within high-yield, but the flows are not reflecting it. jeff: going back to the china thing, i think the market is also taking a lot of comfort in this narrative that this is an administrative tightening. it is regulatory driven to clamp down on financial speculation, and i think there is a view that it is not a fundamental growth for a supply-demand type of situation and i think the market is buying into that. however, i do think you have to be careful because these are not exactly precision instruments that they are using. so the potential for an accident or overshoot exists.

to the extent that china has been the epicenter of the reflation trade, anytime they are tightening or there is something going on there, i think you need to pay a bit more attention. jonathan: i love how much we trust the government with a multi-trillion dollar company. i am not sure we would do that with a business. jeff cucunato, thank you so much. greg davis is sticking with us. coming up is the auction block. calling out the bond bulls after a lousy treasury auction. we will wrap up the the week for you. this is "bloomberg real yield." ♪

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jonathan: from new york city, i am jonathan ferro. this is "bloomberg real yield." i want to take you to the auction block, where commentary this week caused a little unease in the $62 billion in the treasury auctions. the $15 billion 30-year bond sale saw wall street dealers stuck with the largest share since september, while the $23 billion 10 year auction had primary dealers absorbing a larger than usual amount, it has been more than two years since they drew more than the market expected. that drew the attention of one person. he wrote "lousy 10-year treasury auction. where are all the investors that turned bullish in 2015 talking -- in 217 talking about 150? " apparently you are meant to buy low and sell high. let's bring in our roundtable, greg davis. oksana, the twitter account raised a lot of eyebrows. i want to ask you to respond record in mr. gundlach.

but the story really is that the market has changed in terms of positioning. if you're looking at futures, coming into the year, huge short, now a marginal long. what do you make of how the market is set up in treasuries? oksana: the market is still massively long, this kind of risk generally. long, traditional, interest rate-driven fixed-income risk. let's get that very clear. any amount of open short interest out there that fluctuates is meaningful and important to follow. generally, if you look at individual portfolios, institutional portfolios, and think about the risk parity funds, there are volatility driven. think about the amount of leverage they are probably amassing. they are probably at or about max leverage and any kind of high frequency trading portfolio is probably low. it is a massively long trade. i think talking about investors being short is way too premature until we actually see rates move up and see how portfolios react. jonathan: greg davis, you are in

a privileged position to see the flows coming across the desk. as you look at fixed income, talk about the amount of money going into something like treasuries over the last five or six months? greg: we have been seeing it, coming across the complex in a variety of areas. in a broad-based funds that are in exhibit treasuries, corporate bonds, products. there has still been a various things. there has still been a lot of interest in investment products where you are getting additional yield and you're picking up that relative to the treasury market. things that have somewhat moderate to low levels of duration and some credit spread pick up our areas -- are areas we are seeing a lot of interest from investors. jonathan: the conversation that dominated the asset class was what was going to happen with d.c. and the risk was to the downside. i think the optimism from investors that i am speaking to is kind of right down here and

if the risk to the upside that if d.c. can deliver something fundamental it will change? jeff: i think absolutely. we were probably overly optimistic about the process and the timing and there is still enormous challenges in terms of the legislative process. but to the extent that now i think investors have downshifted with with respect to the expectations around policy, if you get something right where it is policy that is truly reform and not just stimulative, there is real potential for markets to react. oksana: i wanted to add one different perspective. i agree with everything jeff said but a lot of the discussion is around rates and when they are moving up and what path the fed should take. it is just on fundamentals. economic indicators are generally constructive in the u.s. and europe, but let's not forget about the technical picture. because that is really important. on one hand, if you look at the

three largest holders of u.s. treasuries and what they are doing, we know now the fed -- it has been suspected all along, but they said they are going to reduce the size of the balance sheet. there is $650 billion through the next year coming through due to that maturing. you have got the next two largest holders, japan and china, reducing holdings of treasury's since january of last year. hundreds of millions of dollars off their balance sheet treasury. and then you have banks which have doubled their treasury holdings over the last five years. what are they going to do if we do see some deregulation which i think that is one thing that is certainly reasonable to expect. jonathan: let's recount one of those themes, what is the balance sheet underlining at the end of the year look like? oksana: i think there will be a lot more conversation around it. i think it is hard to put any kind of specifics around it, especially in terms of how it will affect the market. generally, the market stands toward the fed. whether it is the hiking or the rhetoric, it has been a dismissal.

jeff: i think the fed has been sensitive about not disrupting markets that i think the balance sheet unwind will be gradual and i think they will not simply let whatever matures runoff. but my expectation would be that they would set a monthly limit that they would allow to runoff and that will be much more gradual than letting the $650 million -- or billion over the next year run off. jonathan: greg davis, is that how you view it? almost a nonevent? really? greg: i would not say a nonevent, but the devil is in the details. i think it will be gradual and you are likely to see some kind of high pause in terms of the rate hike cycle is the fed tries to figure out what impact the reduction of the balance sheet will have. we think it will be unlikely you see both of them happening at the exact same time, that they will take a pause on the hiking cycle to see how the balance sheet unwind impacts the marketplace. jonathan: a quick check on the

market. treasuries throughout the week and yields grinding lower, down by about two basis points. a minimal move higher. approaching 3%. still ahead on the final spread, it is the week ahead featuring the new silk road, president trump going on tour. this is "bloomberg real yield." ♪

jonathan: from new york city, i am jonathan ferro. this is "bloomberg real yield." it is time now for the final spread. coming up over the next week, the chinese president xi jinping hosting world leaders, including the russian president vladimir putin as he promotes his $500

billion trade and infrastructure plan. president donald trump beginning his first international tour. some things on the agenda coming up in the next week. i want to bring in our round for a few final thoughts, including greg davis, oksana aronov, and jeff cucunato from blackrock. a question coming in from a viewer via the bloomberg terminal. this one for you, oksana. on a default adjusted basis, isn't em better? oksana: the answer to that question will very much depend on what part of em. as i said, it is differentiated. if you look at the indices very simply and you are getting paid $250 over em and $850 over in not confuse quality with safety. -- over in triple c and rated high yields, do not confuse quality with safety. even if you assume 1% of default in e.m. versus 10% default in that triple c category, you are better off and you have a much clearer picture of what your default -- what your recovery

may be in the high-yield space than you do in em because this year we are finding rules are meant to be broken. they never default, right? and we have puerto rico nonetheless. these questions, there are no set answers to them and you have to consider all the variables. jonathan: this is the rapidfire round where i ask you one question and it is one word answers only, and i begin greg davis. more complacency in the u.s. or europe for the sovereign base? greg: u.s. oksana: europe. jeff: u.s. jonathan: buy or sell. greg: sell. oksana: sell. jeff: buy for now. jonathan: long or short energy. greg: long. oksana: long, but hedged. jonathan: long or short energy.

jonathan: here is the final question for you. on the 10-year treasury, do we see 2% before 3%? 2% before 3%, yes or no? greg: no. oksana: predicting short-term -- jonathan: yes or no? oksana: i would lean toward no. jeff: yes. jonathan: my thanks to our guests. thank you very much for your time. from new york for now, that does it for us. you have been watching "bloomberg real yield." ♪ these days families want to be connected 24/7.

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