♪ 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 more momentum. retail sales fade and inflation rolls over. the fed says it is transitory, janet yellen says it is falling short. too premature to conclude that janet yellen-- says it is too premature to

conclude that the trend falling short. loading up on risky assets. dominating the recent junk-bond issues. we begin with a big issue, inflation data injects some doubt into the fed's next move. chair yellen: 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 be 2% 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. >> the combination of low inflation with slow growth will mean everything goes slowly. and like i said, they may never get to the point they are telling you that they will get. >> i view this as a victory to hand it off to the next fed chairman, the rate even with inflation. >> the inflation numbers are probably not going to derail a fed hike this year. but it does matter directly into the sequencing of events. what comes first, the balance sheet reduction or the fed hike? jonathan: and joining me is the

head of u.s. rate strategy at at general.ral -- also, the head of the u.s. fixed income research at morgan stanley. joining us from wisconsin, jim cohan. the chief income strategist at wells fargo funds. guys great to have you. ,let's begin with this it 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 slow down quite dramatically in the last few months, but if you look at the three-month average of the cpi, that actually bounced from zero to 1% this month. i think if you listen to what fed chair yellen has been saying in her speeches, she has turned it away from the slowdown in march and april has transitory factors and more toward for looking data.

so to me the three-month average , could be more relevant going forward. >> i have a slightly different take on that. 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 arguments coming from the rnc, that this is a transitory phenomenon. it is intriguing to one-time affect us. so if you start looking, start looking at some of the data some of the indicators that the fed -- the dallas fed does, or the estimates of what the cleveland fed does, if you look at those you can see it has been consistently going down. and if you look ahead, it is hard to see this get back to the 2% type of target levels over the next few months. it seems challenging to me. jonathan: jim, as we look over a two day semiannual testimony from the fed chair janet yellen, did you sense she was losing a little bit of conviction as well and maybe transitory is not

all that it seems? it is something a little more, something else? jim: i did not get that sense. i think that chair yellen and the majority have communicated a policy markets plan, a policy normalization track that they would like to follow. that involves raising the rates perhaps one more time and beginning balance sheet restructuring fairly soon. the cpi was on the weaker side, no question about it, but i am struck by the fact over the past several 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 during the latter part of the year. and that has affected bond yields as well. so maybe we are still in that pattern. but going back to chair yellen, she is obviously concerned, she wants to see the rate of

inflation move 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 their plan. jonathan: at this point, they have been undershooting their inflation target consistently , historically for decades. you can look at the history of the fed chairs and you have to go on the way back to greenspan -- all the way back to greenspan to see the average inflation rate in and around their actual target. so yellen is failing. do they have a credibility problem? >> i think you are spot on. the goal of reaching 2% core pce 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 above 2%. but barring that short period 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? an additional question, is the balance sheet policy data dependent or independent at this point? >> a bunch of questions there. i do see that, the fed, you know , the balance sheet unwind if you will, our expectation is they will announce in september and start the balance sheet in october. we do expect to see one more hike in december. and i think our expectation is that the balance sheet, the way that they want to do it, is put it on autopilot. set that in motion and until or unless there are some severe issues that warrant any change, put it on autopilot so that there is -- they are setting it

up is they have little uncertainty by the market participants with the market unwind. jonathan: if you are trying to work out the next move, you have the week data -- weaker data on one hand and on the other side the inside of the bias debate away from the market. are you surprised by how many people are out there who think it will be passive management and everything will be ok and stuff will roll off slowly and yields aren't going to march higher in a significant way? >> i think the balance sheet unwind is a underestimated risk in the market. if you look at the amount of duration about to hit the market over the next five years, we in our calculations have come up with roughly $385 billion or so that will hit the market over the next three to five years. that, 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

typened in past fed qe cycles, that tends to get priced up front, not when the, you know, the unwind is happening. right now i think the market is , extraordinarily complacent given the fact that there is that much duration that is about to hit the market. jonathan: jim, do you see that as well? do you think it is a complete the market? -- complacent market? jim: i could not agree more. i think many portfolio managers and professional investors are very complacent with regard to the long end of the market. 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, very badly because, again, it does not take much of an increase with yields given the duration 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 these yield curves and the fact that the federal reserve not be -- will not be buying as much in the backend of these yield curves, to me is a warning, a danger signal. >> i agree. i agree with my colleagues here. i would say that one market has priced it somewhat is the mortgage market. if you look at the mortgage aspects, the options adjusted spreads, in the face of all fed products tightening since the beginning of the year until now, you have the mortgage spreads widen out to not quite back to the pre-qe levels. but to 17 or basis points. pre-qe, they were around 32 basis points.

so we expect another 10 plus basis points of widening yet to come but the market has become , to price some of it. but the corporate credit markets completely, in my view, they are complacent about the risk of -- that is coming from the balance sheet. jonathan: we will talk about that in just moment, talking about credit next. and you will be staying with us. same with jim, from wells fargo funds. coming up, the auction block. junk bonds a little less of a safety net for investors. covenant light. 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, we saw $56 billion in treasuries auctioning and 30 three tens, year bonds coming into the market. i want to focus on the three-year with a ratio of 2.87, higher than the average over the past 10 auctions. direct bidders buying 10%, the most since october. over in corporate, a moody's report pointed out that stated last month that nearly $27 billion of junk bonds had the highest proportion of deals on record with weaker investment connections. that protections. -- protections. investors are so confident about the corporate debt rally that many have dismissed the likelihood of some risky companies going bankrupt. top rated junk bonds are offering even less relative to the history. with the least extra yield over benchmarks since 2007. still with us around the table in new york, our guest from

morgan stanley and wells fargo. -- jim cohan from wells fargo funds. you were talking about this just before the commercial -- the story of covenant light in the junk bond space. walk me through it and whether we should be concerned about it. >> it is the kind of protection that the bond investors get, so -- from the issuers. 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 high-yield loan market, quality deterioration is substantial. in the high-yield loan market, for example, the covenant light is quite ubiquitous. and what you pointed out, the moody has a covenant quality index that has reached the second weakest point in june. so without a doubt, quality has deteriorated. what are the implications? one implication, when you weaken

the covenant, the likelihood of default, when default occurs, it gets pushed out further. but when the default does occur, what you have in a company, post 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 default frequency is one thing, there will be default, but recoveries in the cycle our expectation is they will be meaningful lower -- meaningfully 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 several months is are you adequately compensated for the risk you are assuming and think about the topic and the type of securities we are talking about, jim. i will ask you, you have been adequately compensated for the risk you are assuming in that space? jim: to date the answer has been yes. we have been adequately

compensated. total returns, performance in the investment-grade and in the high-yield markets have been excellent. and even within the investment-grade, the weaker credits, the bbb's and single very well upormed until now. with the advent of more covenants coming into the market and as we know, particularly in the loan market, it moves behooves managers -- portfolio managers to be much more conservative and to be very careful with regards to those issues. we have seen episodes of covenant light 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 overall, the outlook for credit remains quite positive. but it is important to keep in

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

up quite substantially. sizzling we need to look at is spread, that you are getting paid per unit of leverage, , basically compensation for the credit risk you are taking, is nearly at an all-time low. so you are, in that sense -- you are not getting paid for the kind of leverage and risk you are taking. it is true as jim pointed out, , the performance has been good so far, high-yield in particular has been good. but that doesn't 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 whole of the fixed income universe is this huge bid. the previous conversation was about repressing the central bank, maybe completely pricing the phasing out. how does that shape your thoughts? the whole fixed income universe, would we use that word complacency, do you think about that more broadly? >> yes. that whole discussion about takes melight back to the financial crisis.

and this is kind of what is intended from the qe, you are supposed to be going out of the credit spectrum and get the portfolio balance channel to work by expanding the credit spectrum. so now we are starting to see an 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 still really tight. -- change?hange a go >> 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. we want to get a check on the markets have been this week. what a week for bonds, 2, 10, and 30 yields coming in by four basis points on the two-year. on the 10 year, six basis points. 2.91 on a u.s. 30.

still ahead, the final spread. the week ahead features 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. this is "bloomberg real yield." up next, gdp numbers from china club brexit talks coming up as well, more bank earnings after we've heard from citibank and jpmorgan a little earlier on friday, and we have central bank decisions from the ecb and bank of japan. .till with us, our guest ecb is coming up next week, jim. talk to me about it and what you

are expect in because not many expecting much, but mario draghi has had a lot to say. jim: i do not think we should expect very much. i think he will continue to suggest, hits, whatever word we want to use, that they are beginning to train the punch bowl. it, but the area of superlow interest rates and high degrees of central bank stimulus is coming to an end. we are seeing it ending in the united states, canada, perhaps in 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 -- speech cash from president

mario draghi at jackson hole and the market moves on it because they are expecting something flagged ahead of the september meeting. that is how nervous people are about the next move from the ecb. is a justified? >> hypersensitivity is what we call it. i think for the ecb, the trouble is going to be to try to communicate a hawkish message without spooking the market. we saw even a very small nugget of hawkish information caused the bond yields to be prized -- priced very high in a very short amount of time. and bond yields are extraordinarily rich, and they have been rich with the treasuries for a long time. if you look at the bund-treasuries spread, it was around 200 basis points early on. now we have come down to about 175 basis points right now, so the bund-treasuries very much in line with the dollar. and bunds are sensitive to what comes out of the ecb. jonathan: set us up for next

thursday from president draghi. there was debate around whether the market misjudged the speech he delivered at the ecb form. -- forum. is it his job to clarify the message next week and will we might end up with a dovish ecb? jim: i think he may try to clarify a bit, but 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 your central bank, a a portfolio manager has to ask himself why do i own some of this long-duration debt at these extraordinarily low yields? especially the central bank is not going to be as cooperative as it has in the past? jonathan: it will be a fast rapidfire round. another story, we are going to

wrap things up and wrap up this program. one question, one word answers. u.s. inflation -- transitory or a trend? go ahead. subadra: transitory. >> trend. jim transitory. : jonathan: balance sheet policy, data independent or data dependent? go ahead. subadra: dependent. >> independent. jim: independent. jonathan: the next central bank to hike? bank of england, ecb, or the fed? subadra: um, the fed. >> fed. jim bank of england. : jonathan: that is it for us. from new york, this is "bloomberg real yield." ♪

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