30iette: from new york city, minutes dedicated to fixed income. this is "bloomberg real yield. jonathan: coming up, the u.s. economy shows signs of losing more momentum, retail sales fade and inflation rolls over. too scripturet's to conclude the underlying inflation trend is falling short. and loading up on risky assets with little protection. issue, theth the big inflation injecting doubt into

the fed's next move. >> we are very focused on trying to bring inflation up to our 2% objective. >> the fed is still expected to hike rates in december, and if inflation doesn't start moving back to their target, you will have a healthy debate about it. >> whether or not we get a hike in december is dependent on where the inflation data goes. our forecast chose it will be pretty flat. if that's the case, they are not going to hike. >> the combination of low inflation and low growth is going to mean everything goes neverlowly, and they may get to the low point of the yield. >> to you, this is a victory to head off to the next fed chairman. >> the inflation numbers are probably not going to derail a fed hike, but it does matter directly into the sequencing of events. what comes first, balancing reduction or the fed hike? jonathan: joining me around the

table, the head of u.s. rate strategy at softer general. of u.s. fixed income research at morgan stanley. and from wisconsin, the chief income fixed strategist at wells fargo. great to have you with us. let's begin with this word, transitory. it feels like a crutch to validate your monetary policy. how long before that soft inflation data becomes what it is for many people, a trend? >> well, you know, the inflation started to slow down quite dramatically in the last few months, but if you look at thathree-month average actually goes from zero to 1% this month. whatnk if you listen to the fed chair says she has gone -- to me the three-month

average may be more relevant going forward. this is the fourth consecutive month where we have have -- thisand we is just a transitory phenomenon. at thestart looking ,ndicators of the balance trade if you look at those you can start to see that it is really consistently going down. ahead, it is hard to see us get back to that 2% target level over the next few months. jonathan: as we look over a two day testimony from the fed chair do you sense she was losing conviction and maybe transitory

isn't all that it's teams? >> no, i didn't get that sense. i think that chair yellen and a majority of the fomc have communicated with the markets a policy plan, a policy normalization track, that they would like to follow, and that involves raising the funds rate one more time, and beginning balance sheet restructuring fairly soon. i am struck by the fact that over the past several years since the end of the recession we have had this pattern of relatively weak or softer economic data during the first part of the year and then somewhat healthier economic data during the latter part of the year. maybe we are still in that pattern. chair yellen is obviously concerned and she wants to see

the rate of inflation move towards 2% but they can't wait until they get to see 2% before they act. they are acting in anticipation of somewhat stronger inflation data moving or word and i think that is still there plan. jonathan: there inflation target, you can look at the history of fed chairs, you have to go all the way back to greenspan to see the average inflation rate in and around the actual target. bernanke failed. yellen is failing. have they got of credibility problem? >> that's absolutely spot on. the goal of reaching 2% core pce has been a losing goal. if you look back over the last two decades, between late 2004 and 2008, when it had been consistently 2%. but barring that short period of time, you have not been able to achieve 2% on a consistent basis. jonathan: what we saw through

the week was a tendency among fed officials to lean toward the balance sheet policy tool and away from using fed funds rates. is that when you are expecting as well? and an additional question, is the balance sheet policy data independent or data dependent? do see the balance sheet unwinding and our expectation now through september is to start the unwind in october and we expect to see one more hike in december. that the wayon is they want to do it is to put it on autopilot. unless there are similar issues that warned to change, put it on autopilot so the way they are setting it up is to have very

little uncertainty by market participants about the trajectory. jonathan: so if you were trying to work out the next move for treasuries, you have week data, and on the other side you have price incentive stepping away from the market. are you surprised by how many people seem to think it will be the kind of passive management and everything will be ok and it will roll off slowly? >> i think the balance sheet unwind is an underestimated risk in the market. if you look at the amount of duration that is about to hit the market over the next five years we and our calculations have come up with roughly $385 billion or so in duration that will hit the market over the next three to five years. and if you use the what you get from the fed around 40 basis points over the next three years. if you look at what happened in

that tends to get priced upfront, not when the unwind is happening. right now i think the market is extraordinarily complacent. jonathan: is that what you see of the back of this debate, a complacent market? >> yes, i do. i couldn't agree more. i think many portfolio managers and professional investors are very complacent with regards to the long end of this market. yield curves are relatively flat. durations are extremely long, because 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 doesn't take much of an increase in yield 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. of more marketn risk in the back into the yield curves and the fact that the federal reserve will not be , to me it's a warning, a danger signal. jonathan: i agree with my colleagues and i would say that the one market that has placed at somewhat -- if you look the assets spreads, in the face of all sprint products tightening until now we have seen mortgage spreads why did not quite all the way out -- 17 or 18 basis points from zero. pre-qe they were around 32 basis

points, so we do expect more basis points of widening yet to come, but this market has began to pray some of it. but the corporate credit markets, my view, they are completely complacent -- jonathan: we will get into that in a moment. you will be staying with us. next, the auction block. bonds with less of a safety net for investors. we will get into that in a moment. this is bloomberg. ♪

jonathan: from new york, i'm

jonathan ferro, this is "bloomberg real yield." to the auction block, where we saw $56 billion in treasury 10, and 30three, year bonds. ratio higher than the average of the past 10. direct bidders bought nearly 10%, the most since october. 'ser incorporate, a moody report stated last month that nearly $27 billion of junk bonds had the highest proportion of deals on record, with weak investor protections. investors are so confident about debt rallies that many are dismissing the likelihood of some companies going bankrupt. e the leastnds hav extra yield over benchmark since 2007. still with us around the table, our guests.

you were talking about this before the commercial. the story of covenant light in the junk bond space. lock me through it and whether it is something we should be concerned about. >> sure. isn you think about it, it the kind of protection that the bond investor gets from issuers. over the last several years, we have seen a gradual is aulation, and today high-yield bond market and load market, that deterioration is very substantial. market, it isan becoming ubiquitous and as you dy's hasout, moo an index that reached the second weakest point in june. what are the implications of that? one implication, when you weaken

it, the likelihood of the fault, when it occurs, gets pushed out further. but when the default does occur, what you have is the fault recovery, meaningfully lower. recovery, in for the event of a default -- we are talking about high-yield companies -- there will be some default, of the recoveries in this cycle, our expectation is that it will be meaningfully lower than has been the case in past cycles, in particular. jonathan: something we have been trying to get into over the last several months, is are you adequately compensated for the risk you are assuming. thinking about this topic in the kind of securities, are you being adequately compensated for the wrist you are assuming? >> well, to date the answer has been yes.

we have been adequately compensated. total returns, performance, in the investment grade and high-yield bond markets have been excellent. even within investment grade, the triple b's and single a's have performed well. coveted advent more light issues coming to market, and particularly in the loan market, i think it behooves portfolio managers to the board conservative with regard to those issues. we have seen issues of covenant light issuance sparking in the past, and it has hurt investors in the longer run. we have very good economic fundamentals for credit. corporate earnings are fine, cash flow is good. 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 covenant, no question. what needs to be more conservative with regard to credit risk, but overall, the spreads in most of these markets are within reasonable ranges for periods in which default rates have been low. that is i think the best way to put it. >> i will take a different approach than what we just heard. is how much we take are you being compensated for the amount of leverage in these bonds? that highfield and leverage loans, advocate leverage has picked up quite substantially. is spread we have --d per unit of luggage

nearly at an all-time low. sense you are not being paid for the kind of leverage you are taking. performance has been very good so far full top investment in particular has been very good but that doesn't take away from the fact that you are not being paid. inathan: one thing we know the whole of the fixed income the previous conversation was about repricing the central bank, maybe completely pricing the phasing out. how does it shape your thoughts with the whole 16 income universe -- do you think about that more broadly? >> the whole discussion about covenant light takes me back to the financial crisis. this is kind of what is intended

for qe, you are supposed to be going out into the credit spectrum and the portfolio balance channel works. we are starting to see the unwind at the balance sheet and that is what worries me, because as yields go up, are these products going to be able to deal with rising yields? jonathan: spreads are still really tight. is that going to change? >> spreads are tight, and that makes me nervous about adding exposure. because you aren't being paid that much. jonathan: you are sticking with us. i want to get a check on where the markets have been. yields are coming in by four basis points on the two-year. on 10 year, six basis points. spread.ead, the final

the week ahead features decisions from both the ecb and the bank of japan. we will delve into that in a moment. ♪

jonathan: from new york, i'm jonathan ferro. this is "bloomberg real yield." coming up over the next week, gdp numbers from china, brexit talks, more bank earnings after we heard from citi and jpmorgan, and central bank decisions from the ecb and the bank of japan. still with us, our guests. guys, the ecb coming up next week. talk to me about it and what you are expecting. not many people are expecting much, but president draghi has

had a lot to say over the last month. >> well i think we should not expect very much. but at the margin, i think he will continue to suggest, hint, whatever word we want to use, that they are beginning to "drain the punch bowl." they are not removing it, but the era of superlow interest rates and superhigh degrees of central bank stimulus is coming to an end. we are seeing it ending in the united states and canada, perhaps in britain, not so much in the ecb yet, but he is preparing the markets for an eventual move that will reduce the degree of stimulus that the ecb provides. jonathan: you talked about the complacency around the federal reserve. i cannot understand the amount of nervousness around ecb. you get u a scheduled speech, and the market moves on

it because they are expecting something to be flagged. that is how nervous people are about the next move from the ecb. is it justified? >> yes, hypersensitivity is what we call it. for the ecb, the trouble is going to be to try to communicate a hawkish message without spooking the market. very small nugget of hawkish information caused bond yields to reprice very high in a very short period of time. bund yields especially are extraordinarily rich. if you look at the bund treasury spread, it was around 200 basis points earlier on. now we have come down to about 135. it is very much in line with the dollar. bunds are extraordinarily sensitive. jonathan: set us up for next

thursday. there was some kind of debate about whether the market misjudged the speech he delivered at the ecb for. is that his job to clarify that message next week, and does that mean we could end up with a dovish ecb? >> he might try to clarify in a bit, but i don't think the market was incorrect in its interpretation. as we just heard, there is an enormous amount of market risk when yields are this low. the durations are extraordinarily long, the end unless you keep receiving "good news" from your central bank, a portfolio manager has to ask himself, why do i own some of at these duration debt extraordinarily low yields, if the central bank isn't going to be as cooperative as it has been in the past? jonathan: a very rapid fire round. we wrap things up with this program, one question and one

word answers. u.s. inflation, transitory or a trend? >> transitory. >> trend. >> transitory. jonathan: balance sheet policy, data independent, or data dependent? >> dependent. >> independent. >> independent. jonathan: the next g10 central-bank hike, ecb, fed, g10? >> fed. >> said. >> bank of england. jonathan: that's it for us. ♪ these days families want to be connected 24/7.

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