♪ 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 shows signs of losing more momentum. retail sales fade and inflation rolls over. the fed says it is transitory, janet yellen says it is too premature to conclude the underlying inflation trend is 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 their 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 pretty flat between now and the year ends. if that is the case, they will not hike. >> the combination of low inflation with slow growth will mean everything goes very slowly. and like i said, they may never get to the terminal they are point telling you that they will get. >> this is a victory to hand it off to the next fed chairman, a federal funds rate that is essentially even with inflation. >> the inflation numbers are probably not going to derail a fed hike this year. it does matter in 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 general. alongside me also is the head of the u.s. fixed income research at morgan stanley. joining us from wisconsin, jim cohan. the chief fixed income strategist at wells fargo. guys, great to have you. let's begin with transitory .ould it feels like it feels 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 pivoted away from march and april has transitory factors and more toward for looking data. the three-month average could be

a bit 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 a transitorys is phenomenon. so if you start looking, start looking at some of the data some of the indicators that the dallas fed does, estimates of what 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% type of target levels over the next few months. it seems very 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 of the fomc have communicated with the markets a policy plan, a policy normalization track that they would like to follow. that involves raising the funds rate 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. 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 their plan. jonathan: at this point, they have been undershooting their inflation target consistently for decades. you can look at the history of the fed chairs and you have to go all the way back to greenspan to see the average inflation rate in and around their actual target. bernanke failed. yellen is failing. do they have a credibility problem? >> i think you are spot on. the goal of reaching 2% core pc 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 borin 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 lean 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. and 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 there is severe issues that warrant any change, put it on autopilot so that there is -- in

and the reason 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 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 an 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 happened in past qe type cycles,

that tends to get priced up front not after the announcement -- or i so say not when 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 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 very 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 federal reserve 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 options adjusted spreads, in the face of all spread 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. 17- 18 basis points. they were around 32 basis points.

we expect another 10 plus basis points of widening to calm, but thus yet to come, but the market has become the price some of it. but the corporate credit markets completely, in my view, they are complacent about the risk of coming from the balance sheet. jonathan: we are going to get into that in just a moment. we will talk about credit next. and you will be staying with us. and jim, from wells fargo funds. up next coming up, the auction , block. junk bonds with a little less of a safety net for investors. covenant light. we will get into that in just a moment. this is "bloomberg real yield." ♪

♪ jonathan: from new york city, i'm jonathan ferro. this is "bloomberg real yield." i want to head to the auction block now. this week, $56 billion in --asuries auction auctioning tens and 30 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. 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 proportion of deals on record with the week investment 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 their history with the least extra yield benchmarks since

2007. still with us around the table from new york, our guest from morgan stanley and 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 it is something we should be concerned about. >> it is the kind of protection that the bond investors get 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 the 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 quality index that has reached the second weakest point in june. 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. when the default does occur, what you have in a company, post default recovery is going to be meaningfully lower than fully covenant 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 than has been the case in the past cycle, in particular because of covenant light. jonathan: something we've been trying to get into on this program over the last several months is are you 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 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. even within the investment grade, the weaker credit, bbb's and single a's have been good up performed very, very well. with the advent of more covenants coming into market and particularly in the loan market, it behooves 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 spreads 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: vichy. >> 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. we have seen investment-grade in high-yield and leverage loans, adequate leverage has gone up substantially. the spread per unit of leverage, basically 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. it is indeed 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 fixed income universe is the huge bid. a lot of it is because of the central bank put. the previous conversation was about repricing the central bank, maybe completely pricing the phasing out. how does this shape your thoughts, not just on treasuries but the whole universe when we use complacency -- you think about that more broadly? >> well, yes. the whole discussion about covenant lite takes me back to the financial crisis. and this is kind of what is

intended from the qe, you are supposed to be going out the credit spectrum and get the portfolio balance channel to work by expanding the credit spectrum. 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. spreads are still 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. we want to get a check on the where the markets have been this week. yields coming in by four basis points on the two-year. on the 10 year, six basis points. still ahead, the final spread. the week ahead features

decisions from both 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. gdp numbers from china brexit , talks coming up as well, more bank earnings after we've heard from citibank and jpmorgan a little earlier on friday, and we get central bank decisions from the ecb and bank of japan. still with us, our guests including jim cohan from wells fargo. the ecb coming up next week, jim. talk to me about it and what you are expecting because not many expecting much, but 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 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 super high degrees of central bank stimulus is coming to an end. we are seeing the ending 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. speech fromheduled 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 it justified? >> high sensitivity is what we -- 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 high in a short amount of time. bund yields are specially 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. is it his job to clarify the message next week and will we have a dovish ecb? jim: i think he may try to clarify 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 the yield our this low. the durations are extraordinarily long. unless you keep receiving good news from your central bank, a portfolio manager has to ask himself, why do i own 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 know the 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. james: transitory. jonathan: balance sheet policy, data independent or data dependent? go ahead. subadra: dependent. >> independent. james: independent. jonathan: the next central bank to hike? subadra: um, the fed. >> fed. james: bank of england. jonathan: that is it for us. from new york, this is "bloomberg real yield." ♪

♪ nejra: coming up on "bloomberg best," the stories that shaped the week in business around the world. an email trail raises questions for the white house. janet yellen takes questions on capitol hill. some big banks answer investor questions with earnings reports. >> it is almost an embarrassment being an american citizen traveling around the world and listening to the stupid -- we have to deal with in this country. nejra: central bank official share exclusive insight into monetary policy. >> at that low level you would have historically seen more inflation pressures. we are not. >> as long as necessary, we will implement