>> from new york city, i'm jonathan ferro, this is bloomberg real yield. >> expectations and stressing balance sheets of energy companies. the reflation trade continues to break down. the treasury curve is the flattest since 2007. and credit investors put their foot down after companies get greedy, looking for even lower yields. we start with a big issue -- inflation expectations continue to break down, weighing on a yield curve.

>> the interest rates in the u.s. are still high yield. that is keeping the long end -- i think the flat thing has more room to run. >> it is the lack of faith we have been seeing for the last seven years. it is a lack of faith in the administration, the lack of faith in the qe in other parts of the world that are keeping bond yield suppressed. >> the expectation that nothing is going to change and it is the business as usual, i think that is an incorrect interpretation. i think we will see curves steepening again as the right hand tale of the policy mix begins to unfold. >> if you look at most people in the fed, they have been around the block. they have seen inflation pick up when no one expected it to, and they are responding in a way that their life experience dictates.

>> the one sign that is waved in front of the market everyday is oil prices. they have been heading in one direction for a while now, and that is having a big impact, at least on the bond market. jonathan: let's bring in our roundtable in new york, greg davis, global head of fixed income at the vanguard group, kathy jones, chief fixed income strategist, and from california, i am pleased to say that michael buchanan joins us as well. guys, great to have you on the program. let's start with the big chart. it is the treasury curve, twos versus 30's, and it is the flattest since 2007, 138 basis points right here, right now. greg, when you look at that chart, what is the signal, if any, it is giving to you right now? greg: it is saying that the market is clearly pricing in. the fed has been quite active. we have seen a four rate hikes over the course of the last year or so, and that is causing the curve to flatten a bit.

and the longer end of the curve is being -- down by the fact that ultimately we have not seen much in terms of inflation. that is getting investors an avenue to stay invested. jonathan: kathy, typically we talk about the yield curve flattening and maybe at some point down the road, inverting. is it different in 2017? kathy: i don't think the fed is going to go so far that they will push it to inversion anytime soon, but i do think that the market might be underestimating how much the fed is actually going to move ahead, and the possibility that the fed actually might be right and inflation picks up down the road. jonathan: michael, this flat yield curve story that so many people reference, some people say forget about it. given the central bank stimulus elsewhere, this is not your 2007-2006 story. what do you think, mike? mike: i think a little bit of it is simply relative value. if you look around the globe, you will see that rates are low almost everywhere. so, it is only natural to think

that relative value might actually bring investors to migrate into the u.s. market. as you get in a tightening environment, it is not totally shocking that you see curve flattening. i do think there is an abandonment of the reflation swing or trade, and the pendulum can swing both directions. we saw it with the euphoria initially in a lot of the trump initiatives and policies. i think it will swing the other way now. jonathan: kathy, the data is going against them, the commodity moves against them, and the markets as well. kathy: absolutely. we have gone from the reflation trade to the almost deflation trade. but i think that when you think

about what the fed is looking at, they are looking at financial conditions that are extremely easy right now. one of the reasons they want to raise rates is just to get back to normal. they want to avoid asset price bubbles, they want to get ahead of this. there is nothing standing in their way to raising rates. we still have negative short-term yields right now. from the fed's point of view, they have plenty of runway. greg: the other part you need to take into consideration is they will start on the whole balance sheet normalization process. it has been well communicated, and the market is taking it in stride, but the reality is we need to see when we will start implementing it, whether there

is any adverse reaction at that point in time. that does give them reason to be a bit cautious. jonathan: when the -- buyer sees the hike, do you see a policy error on the horizon? greg: it is hard to see if it is on the horizon, but they have been saying for numerous months they will be driven by the data. so, as long as they stay flexible, i think it will be fine. but if they get too far ahead, that is where you run into potentially having a policy mistake. jonathan: they say they will be driven by the data, but we are still trying to figure out what the data and what the reaction is. mike buchanan, something that has come up on the program before, and i will bring it up again, we have a 10-year right now just at 2.1%. you get to the end of 2018 and either someone is wrong or you end up with a flat yield curve. where do you stand on that debate right now? mike: it is interesting. i think you do have a big disconnect right now between what the fed is implying through the dots versus what is implied in the market. and you know, the question is, who is ultimately going to be right? our view is that the market is probably more right here.

over time, you will see the fed dots come down. they are going to imply certainly less tightening than they are implying right now. that is where we are going. we do think the economy has some real challenges in front of it, and we think the data will validate that as we move forward. jonathan: is it a case of the market being right or the fed being right or one being wrong? or actually maybe this is just where it is going. maybe what people anticipated coming into the year when the fed was going to hike, you get a steeper curve, that is just not what is going to happen here. greg: kathy made the point earlier that there are a lot of expectations in terms of what was going to happen in d.c. in terms of regulatory reform, tax reform. and you know, the impact of those policies was expected to start potentially impacting the market this year, and we have seen it be delayed. it is not surprising that we see some of this reflationary bias in the market being pulled back out again. jonathan: let's talk about actionable trades.

when this is your framework for thinking, at the start of the year everyone said, "stay away from duration." how are you thinking about the treasury market right now? greg: for us, we have been neutral on duration in general. it is hard to have a longer conviction in our active portfolios. what i would say is if we did see some cheapening of 10 year treasuries and some unwind there, we would need biased toward adding duration to the funds specifically because the long-term headwinds will exist. kathy: we have a similar stance. we are trying to capture that between three years and seven years. if we were to get it back up at rates at 2.5%, which is where we see the 10-year yield them a we -- yield this year, we would probably lengthen the duration somewhat. jonathan: we have seen the highs on a 10-year. is that it? greg: i believe so. jonathan: we are done and dusted. we can go home for the rest of the year. greg davis sticking with us, kathy jones, alongside mike buchanan from western asset management. that wraps up the conversation on treasuries. coming up, we had to the auction block. three deals polled as investors push back and ask for higher

yields. we will get into that in just a moment. this is "bloomberg real yield." ♪

♪ jonathan: i am jonathan ferro. this is "bloomberg real yield." i want to head to the auction block where the search for yield comes to argentina. a country with a 200 year history, 75 of those in default. manages to convince investors that its track record -- the company sold $2.75 billion in a century bonds. back in the year us, a sale of 0.88%. primary dealers took only 15.5%, the lowest ever in data going back to 2010. the bid to cover ratio was the highest since 2011 investors, here is. a story for you, put their foot down. they demanded high yields. virgin media, charter communications, and berry, all pulled debt deals this week. looking for lower yields.

they cited market conditions. back at our roundtable, greg davis from vanguard group, kathy jones from schwab center for financial research and michael buchanan from western asset management. mike, credit is your world here at let's talk about it. because companies are getting a bit greedy, is this a good thing that investors are pushing back a little bit? mike: i think it is a great thing. what it really shows is discipline in the market. obviously, we have had a little bit of a wobble in the credit market, and investors, rightfully, want a little more yield, they want a little more spread are so those negotiations broke down. i think the key thing is that these companies, if they wanted to, if they opted to take advantage of the deal, they could have gotten a deal printed this week. for the most part, what they did, they just did not like the

valuation. i think the market is the, and for me, that is the big takeaway here. jonathan: greg davis, about companies coming to market because they do not actually need to come to market because they do not need the money, what does that say? greg: it is something we have seen the last several years. it has really been around financial engineering doing increasing dividends, doing stock buybacks, things of that nature versus actually using the capital to invest in their businesses and push growth that way. it has been more or less about financial engineering of the balance sheet. jonathan: sometimes i turn on the tv, and i will not say which channel, but you hear so much about credit. it sounds like absolute carnage, but high yields have done so well in 2017. ccc has been the outperformer in 2017. why is high-yield getting such a negative rap still? greg: i think there is a lot of fear and whenever you see

weakness in the energy space. people get concerned about high-yield, because we saw that movie before. we saw that last year where there was pressure in the energy space and it bled through to the high-yield indices. we have not really seen that yet. the high-yield index was up almost 5% this year, which is a really strong number when you think about the backdrop that we are in. jonathan: and they supply store has been supportive, too. kathy: it has mostly been an investment grade issuance has been strong. you know, as greg said, the spread are so narrow, we are at post crisis lows or very close to it. and one would think that with financial conditions likely to tighten, that is not good for high yields. so, i would think it is right that investors are demanding more yields. jonathan: greg, suppose that financial conditions may or may

not tighten. you take this conversation back into the federal reserve debate, they have been hiking, but financial conditions have gotten easier. why should that change? greg: it'll be a function of whether the market is more aggressive the band what the fed is pricing in, and what is the action, and what is the equity market? at the end of the day, rates are relatively low in the u.s. and overseas. it has been very supportive for the equity market. those are all contributing factors. jonathan: mike, this time a couple of years ago, we had crude in the bear market, and

people were talking about blood on the trading floor and absolute carnage. it is different this time. why? mike: i think it is different for a few reasons. one is we saw what happened in 2015 and early 2016 -- production came off-line, companies learned how to survive or else they did not survive, and quite frankly, a lot of these companies ended up defaulting. i think it is really interesting when you think about energy within high-yield. what you did is defaulted i would say it is the most vulnerable cohort within energy, you defaulted that out of the market, and you are left with the stronger cohort. that stronger cohort now has more discipline, more balance sheet strength, and what they have done is, like i said, they learned how to adjust their cost structure. i do not think this is going to be a repeat of what we saw in 2015 and 2016. in fact, what we are doing is we are looking at this as an opportunity. energy spreads and energy yields have gone from 6% now back to 7.5%. i think there are really high quality companies that you can buy and make decent returns on. jonathan: is that sector-specific, mike? mike: i would say it is even credit-specific. you cannot go out and randomly buy energy. you really have to look at -- if you are looking at exploration and production companies, what their cost structure is, what their leverage is. there are a lot of considerations. that is how we are taking advantage of it. we are picking through the entire sector and looking for those companies that we know

have the management and the financial wherewithal to write out a prolonged period of crude oil. we do not know when it will recover. jonathan: do you have that you as well, kathy? kathy: yes, i do. one of the things that concerns us about the high-yield index is energy. if you are sort of passively investing in energy and high-yield right now, or high-yield, you are getting a lot of energy exposure and not taking the approach that mike is taking and being very disciplined about the approaches you are looking at. jonathan: greg, weigh in on the active-passive debate. how do you navigate that story at vanguard? greg: we see most investors being broadly diversified when it comes to index products, that will serve investors well, but we offer both. we offer active as well as index. but the main story for us is around low-cost, being able to do it that when we are in a lower yielding environment, you do not want to give away too much by paying higher expense ratios. that is really important in this type of environment. kathy: i would agree with that 100 percent. keeping the cost down is one thing you can control in a

low-yield world, but in this case, because of the potential for energy to be a problem, that you might want to switch to active for that segment. jonathan: looking at high yield, we had a chart of default rates on the screen a little bit earlier. i always find it interesting when people bring up default rates and justify the long positions, because default rates are ok until they are not ok, and then that is a problem. that is a tough justification for me. is it for you? greg: it absolutely is. it is not where default rates have been, it is where they are going. jonathan: where are they going? greg: i think it is tough to call. as long as you have a strong economy, you do not have too

much of a disruption in terms of fundamentals, in terms of the pricing of oil, and things of that nature, i think you can hover along with relatively low default rates. to the point kathy was making earlier, when you're in an environment where the fed wants to tighten financial conditions, you have to worry were at some point they may go too far, and that may have a negative impact on the higher beta sectors. kathy: and that is dependent upon their access to credit. the default is up when they cannot get access to credit anymore. if oil prices are low enough,

and some of these companies are vulnerable and their bank loans start to get called, that is when you run into financial issues. we haven't seen those yet. jonathan: one of the areas of the markets where people get nervous because spreads are very tight. when you get a little bit of a breakout, even by 10 basis points, people get very nervous and start thinking about running to the hills. if the default rates are not a good forward-looking indicator, what do you use as a type of forward-looking indicator? mike: what we are doing is trying to look at those metrics that ultimately will influence or lead to default rate. we're looking to cash flow generation. we are looking at overall health of the balance sheet.

this very robust overwriting environment that we have gone through has allowed a lot of the high-yield companies to effectively term out their debt. the refinancing risk that faces a lot of these challenged companies have been alleviated, because they have been able to access the market. they have been able to push out maturities or replace higher coupon debt with lower coupon debt. in general, we are looking for those signals, those fundamental factors that over time will lead to fundamental trends. you are watching "bloomberg real yield." ♪

jonathan: from new york city, i am jonathan ferro. this is "bloomberg real yield." it is time for the final spread, the week ahead. coming up over the next week, president donald trump will be meeting with india and south korea. we will see if the fed clears away for some of the biggest banks in the u.s.

we will also get the financial stability report as well and hear from governor mark carney. still with us to discuss, greg davis from the vanguard group, kathy jones and michael buchanan. greg davis, a year since brexit, and it is a big story for global bond markets, and now it is not. why isn't it anymore? greg: because i think people have realized it will take longer to figure this out then people initially expected. you saw a significant market reaction right away, but the

devil is in the details. it will take time to figure that out here. jonathan: kathy, who would have thought a year later now we would be talking about potentially a rate hike. why are we talking about a rate hike? kathy: the currency market is feeling the impact of brexit. the sterling is way down versus the dollar, versus the euro. that is what is driving inflation right now. import prices. as much of what people in the u k, as you know, consume is imported. we are starting to see inflation got, mostly because of the currency effect. jonathan: interesting to me that we talked a lot about the central bank forward guidance in how wrong they can often get things. i remember when the bank of england was talking about raising interest rates when the federal reserve was doing the same thing with unemployment at 6.5%. it feels like it is very much a

moving target in quite a significant way. greg: it definitely feel that way, and we have seen that in europe and other countries as well. the reality that you will want to see evidence that there is an inflation pressure building up, but we really have not seen it so far. jonathan: do you think they continue to have faith in the phillips curve? greg: i think you have to. jonathan: guys, we have to wrap things up with the rapid fire round. i want to put you in boxes and give you some quick questions, and if you keep your answers to a couple of words if you can. the yield curve right now to year end, flatter or steeper? greg: steeper. kathy: slightly steeper. mike: i'm going to say slightly flatter. gregory: pick up the pieces. a run for the hills, high-yield? greg: pick up the pieces. kathy pick up the pieces,: reluctantly. michael: you definitely pick up the pieces.

jonathan: there we go. that wraps things up. great to have you with us on the program. from new york, you have been watching "bloomberg real yield"" ♪