♪ jonathan: from new york city for our viewers worldwide, i'm jonathan ferro for 30 minutes dedicated to fixed income. this is "bloomberg real yield." ♪ jonathan: coming up, the u.s. economy showing signs of losing momentum with a retail sales fading and inflation rolling over. the fed says it is transitory, janet yellen says it is premature, with the trend falling short. loading up on risky assets. dominating the recent junk-bond issues. we begin with a big issue, inflation injecting down to the next move for the fed. >> we are very focused on trying

to bring inflation up to our 2% objective. >> the fed is expected to hike rates in december and if inflation does not move back to the target they will have a pretty healthy debate about that. >> whether or not we get a hike in december depends on where the inflation data goes. on our forecast, inflation will be flat between now and the end of the year. if that is the case, they will not hike. >> accommodation of slow growth and low inflation will mean everything goes slowly. pointay never get to the they are telling you that they will get. >> to hand it off to the next fed chairman, the rate even with inflation. >> the numbers probably not derailing a headache this year -- a hike this year. what comes first, the balance sheet reduction or the fed hike? jonathan: and joining me is the

head of u.s. rates -- along with me also, the head of the u.s. fixed income research at morgan stanley. from wisconsin, jim cohan. guys great to have you. it's begin with transit -- seems like a crutch. how long before the soft inflation data becomes what it is for many, a trend? >> the inflation data has started to move dramatically in the last few months, but if you look at the three-month average, of the cpi, it goes from zero to 1% this month. i think as you listen to what the fed chair yellen said, she has turned it away from march and april toward the transitory factors and more toward for looking data.

the three-month average could be only going forward. >> i have a different take. this is the fourth consecutive month where we have seen cpi numbers drop. it is hard to make the argument that you have seen some of those coming from -- that this is a transitory phenomenon. so if you start looking, start looking at some of the data some of the indicators that the fed does, or the cleveland fed does, if you look at those you can see it has been consistently going down. if you look ahead, it is hard to see this get back to the 2% target levels over the next few months. it seems challenging. jonathan: jim, as we look over a two day semiannual testimony from janet yellen, did you sense she was losing conviction as well and maybe transitory is not

what it seems? maybe something else? jim: i did not get that sense. i think that the majority of them have communicated with the markets and policy plan, a policy normalization track that they would like to follow. that involves raising the funds rate perhaps one more time and working on balance sheet restructuring fairly soon. the cpi was on the weaker side, but i am struck by the fact over the pastoral years, since the end of the recession, we have had a pattern of relatively weak or softer economic data during the first part of the year, then somewhat healthier economic data for the latter part of the year. and it has affected bond yields. maybe we are still in that pattern. going back to chair yellen, she is obviously concerned, she wants to see the rate of inflation moving toward 2%, but remember as she said they cannot

wait until they get to 2% before they act. so they are acting in anticipation of somewhat stronger inflation data moving forward and i think that is still there plan. jonathan: at this point, they have been undershooting consistently for decades. you can look at the history of the fed and you have to go on the way back to greenspan to see the average inflation rate in around in their actual target. so yellen is failing. do they have a credibility problem? >> i think you are spot on. the goal of reaching 2% has been a loose goal. if you look back over the last few decades, there has been some time between 2004-2008 when the core pce has been consistently 2%, but barring that short amount of time we have not been able to achieve 2% on a consistent basis. jonathan: we did see through the

week a tendency among fed officials to be leaning toward the balance sheet policy, and away from using the fed funds rate. is that what you expect as well? is the balance sheet policy data dependent or independent at this point? fed, youee that, the know the balance sheet if you will, our expectations is they will announce in september and start the balance sheet in october. and we could see one more hike in december. is i think our expectation that the balance sheet, the way that they want to do it, is put it on autopilot. put it in motion. and until there is severe issues that warrant any change, put it --autopilot so that there is in the way they are setting it

up is the have little uncertainty by the market participants with the trajectory of it. jonathan: if you are trying to move -- work out the next move, you have the weaker data on one the and on the other side inside of the bias debate away from the market. are you surprised by the people who think it will be passive management and everything will be ok and stuff will roll off slowly and yields were not marked on in a significant way? >> i think the balance sheet unwind is a risk in the market. if you look at the duration about that the market of the next five years, we in our calculations have come up with so that$385 billion or will hit the market over the next 3-5 years. if you use the betas that you get from the fed, it amounts to about 40 basis points over the next three years. typically if you look at what happened in past qe type cycles,

it gets priced up front typically, not win the, you know, the unwind is happening. i think the market is extraordinarily complacent right now given the fact that there is that much duration that is about to hit the market. jonathan: do you think it is a complete the market? jim: i could not agree more. i think many portfolio managers and professional investors are complacent with regard to the long end of the market. the yield curves are relatively flat, durations extremely long because the yields are so low, and we see the impact of that if we get a correction, for example as we did last year starting around right now. the long end of the market performed very badly because, again, it does not take much of an increase with yields to produce rather substantial price declines. and we are going to get more duration in this market, partly

because of the balance sheet restructuring or the reductions in the balance sheet will be in notes and bonds. so that combination of more market risk in the back end of the yield curves and the fact that federal reserve not be buying as much in the backend of the yield curves, timmy is a warning, a danger signal. >> i agree. market has that one placed it somewhat is the mortgage market. if you take a look at the spread, in the face of all things tightening since the beginning of the year until now, you have the mortgage spreads widen out to not quite back to levels.qe they were around 32 basis points. so we expect another templates

basis points of widening to calm, but the market has become the price some of it. but the current markets completely, in my view, they are complacent about the risk of coming from the balance sheet. jonathan: we will talk about credit next. and you will be staying with us. and jim, from wells fargo funds. coming up, the auction block. a little less of a safety net for investors. we will get into that. this is "bloomberg real yield." ♪

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jonathan: from new york city, i'm jonathan ferro. this is "bloomberg real yield." i want to go to the auction block now. this week, $56 billion in treasuries, 30 year bonds coming into the market. i want to focus on the of 2.87,r with a ratio higher than the average over the past 10 options. bidders buying 10%, the most since october. corporates, a midi report pointed out that stated last month that nearly $27 billion of junk bonds had the proportion of deals on record with weaker investment connections. investors are so confident about the debt rally that many have dismissed the likelihood of risk companies going bankrupt. they are offering even less relative to the history. with the least extra yield benchmarks since 2007. still with us from new york, our

guest from morgan stanley and wells fargo. you are talking about this, the story of covenant light in the junk bond space. walk me through it and whether we should be concerned about appeared -- about it. >> it is the kind of protection that the bond investors get, so over the last several years we have seen a gradual deterioration in the quality of the covenants and today in the high-yield bond market and alone market, quality deterioration is substantial. for example, the covenant light is a big what is. and what you pointed out, the moody has a quality index that has reached the weakest point in june. without a doubt, quality has deteriorated.

what are the implications? one when you weaken the covenant, the likelihood of default. default occurs and it gets pushed out further. when the default does occur, postyou have in a company, default recovery is going to be lower than fully recovered bonds. the prospect for recovery, in the event of default, remember we are talking about high-yield companies so their frequency for default is one thing, there will be default, but recoveries in the cycle our expectation is they will be meaningful lower than has been the case in the past cycle, in particular because of covenant light. jonathan: something we've been trying to get into over the last couple months is are you compensated for the risk you are assuming and think about the securities we are talking about, jim. you have been adequately compensated for the risk in that space? jim: to date the answer has been

yes, we have been compensated. performance in the investment-grade, they have been excellent. even within the investment grade, the weaker credit, and lee' -- bbb's single a's have been good up until now. and with risk coming into the market, particularly in the loan market, it behooves portfolio managers to be conservative and careful with regards to those issues. we have seen episodes of covenant like issuance spiking in the past and it has hurt investors in the longer run. currently, we have very good economic fundamentals for credit. corporate earnings are fine, cash flow is good and there are some episodes of weakness, but over all the outlook for credit remains positive. it is important to keep in mind

that those covenants can be helpful when things deteriorate and we are getting the weaker covenants, no question. one needs to be more conservative with credit risk, but overall the spread in most of the markets are within reasonable ranges for periods in which default rates have been low. i think that is the best way to put it. jonathan: go ahead. >> i think a different approach than what we heard from jim. the approach we take is how much are you compensated for the amount of leverage in these bonds, in those instruments. we have seen with high-yield and leverage loans, adequate leverage has gone up since essentially. -- gone up substantially. leverage, per unit of

compensation for the credit risk you are taking, is nearly at an all-time low. in that sense you are not getting paid for the kind of leverage and risk you are taking. performance has been good so far, high-yield in particular has been good. but that does not take away from the fact that you are not being paid for the leverage you are taking on today. jonathan: one thing we know in the fixed income universe is the huge bid. the previous conversation was about repricing the central bank, maybe completely pricing the phasing out. how does the shape your thoughts, not just on treasuries but the whole universe when we use complacency -- you think about that more broadly? >> yes. the discussion about covenant lite takes me back to the financial crisis. and this is kind of what is

intended from the qe, you are get the to be trying to portfolio balance channel to work by expanding that out. we are starting to see and unwind of that with the unwind of the balance sheet and it worries me a little bit. as the yields go up, are these products going to be able to deal with the rising yields? jonathan: spreads are still tight. they are really tight. will it change? >> they are tight. it makes me nervous about adding exposure to credit, because you are not being paid that much. jonathan: you are sticking with us. guests. we want to get a check on the markets this week. yields coming in by four basis points on the two-year. tenure, six basis points. year, six basis points.

still ahead, the final spread. we have decisions coming from the ecb and bank of japan. we will delve into that. this is "bloomberg real yield."

♪ jonathan: from new york city, i'm jonathan ferro. for our viewers worldwide, i'm jonathan ferro. commit, gdp numbers from china club brexit talks coming up as well, more bank earnings after we've heard from citibank and jpmorgan, and we have central bank decisions from the ecb and bank of japan. guestsith us, our including jim cohan from wells fargo. the ecb coming up next week, jim. talk to me about appeared what

is expected -- about it. talk to me about appeared mario draghi has had a lot to say. jim: i do not think we should expect very much. at the margin, i think he will continue to say just, hint, whatever word, that they are beginning to quote unquote, drain the punch bowl. they are not removing it but the era of superlow interest rates and super high degrees of central bank stimulus is coming to an end. we are seeing an indian in the united states, canada, perhaps great britain. not so much in the ecb quite yet, but i think he is preparing the markets for an eventual move that reduces the degree of stimulus that the ecb provides. jonathan: you talk about complacency around the federal reserve, i cannot understand the amount of nervousness around the ecb. you get a scheduled speech and the market moves on it because

they are expecting something flagged ahead of the september meeting. that is how nervous they are about the next move, is a justified? >> high sensitivity. i think for the ecb, the trouble is going to be to try to communicate a hawkish message without -- the market. we saw even a very small nugget of heart this -- hawkish information caused the bond yields to be prized high in a short amount of time. with the been rich treasuries for a long time. if you look at the spread, it was around 200 basis points early on. now we have come down to about 175 basis points right now, so that treasuries in line with the dollar. nds are sensitive to

what comes out of the ecb. jonathan: set us up for next thursday. there was debate around whether the market misjudged the speech that mario draghi delivered. is it his job to clarify the message next week and will we have a dovish ecb? jim: i don't think the market was incorrect in their interpretation. there is an and or must amount of market risk when the yield our this low. the durations are extraordinarily long. unless you keep receiving good news from central banks, a portfolio manager has to ask himself, why do i own some of the long duration, some of this long-duration debt at these extraordinarily low yields that the central bank is not going to be as cooperative as it has been in the past? jonathan: it will be a fast rapidfire round. you, onethings up with

question, one word answers. u.s. inflation transitory or a trend? go ahead. >> transitory. >> trend. >> transitory. jonathan: balance sheet policy, data independent or data dependent? go ahead. >> dependent. >> independent. >> independent. jonathan: quickly, the next hike coming from the fed or central bank? >> um, the fed. >> red. -- fed. >> bank of england. jonathan: that is it for us. this is "bloomberg real yield." ♪

♪ p.m. in news 12:30 york, 5:30 p.m. in hong kong and -- i may, 12:30 a.m. in hong kong. welcome to bloomberg markets.

♪ from bloomberg world headquarters in new york, top stories on the bloomberg that we are following. in markets, u.s. stocks and bonds rally in along with oil and gold. we pray deck on the moves -- break down the moves. the optimism fueling stocks after president donald trump's election going down a little bit, we break down the earnings from citigroup, wells fargo and morgan chase. and it is july, but winter is coming as game of thrones returns to tv screens, why the company is pulling back on its streaming service. vonnie: we have to wait until sunday for that, but let's get a check on the markets. abigail: the gains not looking large, but we are looking at ec