julie: from new york city, i'm julie hyman in for jonathan ferro with 30 minutes dedicated to fixed income. this is "bloomberg real yield." ♪ julie: coming up, we look at a year ahead in fixed income as investors prepare for a new fed chair. tighten your seatbelts as the yield curve reaches its flattest levels since 2007. it's the last trading week of the year. we review the year that was 2017. we start with the big issue issues of 2017. >> i think the fed is itching,

wanting to raise rates for some time. >> i still think the inflation rate is there. >> it has hit an air pocket. >> we are pleased with what going on in the unemployment picture. >> job creation remains solid. >> the jobs number is a good number. >> the labor market is continuing to heal. >> there is room to maneuver, but we are a long way from full employment and wage growth. it's a long way from where it would be if we were close to it. >> people have confidence this administration cannot not only get the big themes, but can deliver on them. >> if he wants to make everybody happy, including his base, he has the real policy stuff. >> there are a few bleary eyes in london and maybe a few surprised faces. what the business community wants to see now with a new government in place is the economy at the top of the agenda.

>> i think the fed has to wait to see the whites of the eyes of inflation. >> we know the insatiable chase for yield continues. >> should be watchful for excesses or buoyancy getting to a tipping point. >> i imagine janet yellen is doing cartwheels at how well the market has taken the whole balance sheet reduction plan announcement. >> people will rightly interpret the fed can move going into december. we think two or three times next year. >> they view jay powell to be continuing over the next several years. >> that is bailed out a lot of bond investors. returns are good. >> the 800 pound gorilla is whether or not this building corporate leverage which have seen over the past three or four years, is that sustainable or something less benign? >> credit spreads are doing well. if the economy in general in the

u.s. and globally is doing well, i think they will be best there will be some willingness look past the flatness of the curve. julie: joining me is kathleen gaffne, and from pasadena, california is julien scholnick, and ira jersey from bloomberg intelligence. thank you for joining us. there are a lot of issues we have weighed this year thus far, probably the biggest being the flattening of the curve. what happens in 2018? kathleen: i don't have a crystal ball of the flattening of the curve indicates we are in late stages of the economic cycle. i think there is a lot of fear the next stage is recession. i'm not so concerned about that, although i worry about the technicals. we are seeing the curve start to normalize. rates have moved up on the short end. they are going back to normal. it is not really a tightening.

the question is, what does that mean for fixed income returns and does it create selling pressure? julie: what you make of that impression? do we see selling pressure next year that would eventually perhaps result in a steepening once again? julien: i think that is in the big story this year, the flattening of the curve. if you think back, the narrative was that the new administration was going to push progrowth policies, things like tax reform, infrastructure spending, deregulatory agenda. that western asset we were at the view the legislative agenda would take longer to a out. we are concerned inflation could move lower. over the course of the first half of the year he saw some of

that optimism begin to fade and the curve flattened significantly as they realized inflation came in lower. that is what is driving the long end of the curve in our minds. we are in a highly disinflationary environment where it doesn't always follow the upsurge in cyclical strength like it has done traditionally. that could come at some point in the future but you couple this inflation with high debt loads and you end up with low rates at the long end of the curve. julie: we remain with that inflation challenge. we have got a chart that looks at inflation expectations. that's versus the curve. it shows people are not expecting much inflation out there. that continues to be the case. the blue line is the five to 10-year expectations, versus the 2-10 spread. ira, that is not a picture i look at and think inflation is going to perk up in 2018. ira: inflation expectations are not expected to move up.

in that survey you see long-term inflation expectations continuing to move lower. that is a problem for the fed because the fed is expecting people to think there will be more inflation. certainly markets don't think that. that's why you have 10-year inflation breaking even. it's about 2% inflation on average over the next 10 years. that's also the average inflation rate being expected five years from now. you don't have a lot of variability in inflation. for the curve to steepen substantially you do need the outward expectations to go up and they are just not there at all. julie: i was reading your outlook for next year. you're looking at a 10-year yield 2.56% year-end which is below consensus. is that because of the inflation outlook? ira: that is a big part of it. inflation expectations will be

kept in check. as the reserve continues to hike rates in 2018, whether it is twice as the economic team thinks or three times as the dots show, there is an idea that five years now one way or another we will have some kind of cyclical slowdown, even lower inflation that we have today. it will be hard for the long end of the curve this significantly selloff in the environment. the one caveat is what does the ecb do and does the ecb remove accommodations quicker than they specified? that is the one kind of unknown that could potentially steepen the curve some. julie: kathleen, where are you for the end of next year? you have forecasts forward you think yields will be? kathleen: not a real and true forecast, but i think rates will

be higher. i would not be surprised to see 3% on the 10-year easily. i think inflation excitations are really anchored firmly and that if there is any kind of change, the market could really react strongly to any signs of stronger inflation. julie: you think wage growth finally perks up a little bit in 2018? is that where the drive will come from? kathleen: that would not surprise me at all. there seems to be some shortage they are highlighting. snowplow drivers up in maine can't find enough of them. that's a little scary after having her first white christmas in a long time. we are also seeing shortages in the construction sector. truck drivers. there are shortages at one end and the other in terms of skills, highly skilled employees.

i think wage pressures will be moving up. julie: i want to come back to what ira brought up, the ecb. if you look outside the u.s., aside from the inflation question here and the ecb wildcard, how do you think that plays out? what he predicted for next year? julien: the eurozone is interesting. for years they have lagged their recovery the u.s. has experienced. now you're finally starting to see a bit of catch-up in terms of eurozone growth being a positive contributor to the global economy. you are seeing inflation move up slowly, albeit gradually.

our thought coming in was if you get this catch-up in terms of growth to where the u.s. is, that should be positive for the euro. we don't think german bunds below 40 basis points make sense in the growth environment in the context of a global growth environment. the spread between 10-year german rates and 10-year rates in the west is about 200 basis points. pretty wide level, a multi-decade wide level. we expect that the converge over time as those long end rates normalize. it is really mispriced. you have two-year rates of 70 basis points. that is a bit of a difficult market to trade because that mechanically controlled by the ecb. if we have to be short somewhere, we would choose further up the curve at the 10-year or 30-year. we don't see fundamentals in terms of improving growth and inflation justify rates at such low levels. julie: we will button out this part of the conversation. there is much more. everyone is sticking around with us.

kathleen gaffne, julien scholnick and ira jersey. coming up, the auction block. all the talk about brexit did not seen this way investors. we will tell you why, next. this is "bloomberg real yield." ♪

♪ julie: this is "bloomberg real yield." i want to head to the auction block. investors are worried about the debt ceiling in the u.s. the debt to cover ratio was the lowest since january of 2009. in the u.k., financial institutions -- sterling denominated bond sales to $64 billion. the high-yield bond market had a record year with equivalent of $115 billion.

rock-bottom interest rates fueled demand, including for the riskiest notes. i'm back with kathleen gaffne, julien scholnick and ira jersey. thanks for sticking around. i want to pick up on the last point about high-yield and talk about the outlook for next year. it seems in the u.s. the high-yield market, there is not a lot of optimism for high-yield investors from where it turns will be next year. kathleen is shaking her head. we have total return forecast for 2% to 7%. does that sound about right? or is that too much? kathleen: on the upper end definitely too much. much closer to the lower end. the reach for yield can only go on so long. julie: you think this will be the year where we saw a little bit of a pullback in the fall -- i think 'freak out' is too strong of a word, but a little bit of a selloff. then it dissipated.

kathleen: because the reach for yield is still there. you have buyers coming into the market. at some point i believe there will be a buyers strike driven by rates moving up. julie: what do you think for high-yield next year? is this strike coming as well? julien: we still think the fundamentals are constructive for high-yield. we don't think reaching for yield makes a lot of sense at this point in the business cycle. we think it will be a year we can click your coupon. we would be hard-pressed to see the index spread compression he saw in 2016 or 2017, but there are pockets of opportunity. one area we like is the rising start candidates, the upper end

of the high-yield spectrum. double-d rated names. staying up in quality is the trade we like but there is some room for spread compression. julie: speaking of spread compression, ira, you have a chart you have been looking at comparing spreads right now to what we saw in the 2011-2014 cycle. if you look at that chart, what is this telling you about what we could see now? it looks like we are just about as tight here as we were then. ira: basically we are running out of steam. i agree with the other guests. i think what is really important when spreads her this tight, and spreads can stay tight for a number of years. not that spreads being tight necessarily need to have to widen and excess returns are negative, but because of that

you have to be very selective and careful. this is an alpha market, not a beta market. you want to take your specific spot, whether it is individual credits or sectors you think will perform better if there is a hiccup in the market. julie: broaden it out and talk about corporate debt. i'm curious how the tax cuts affect corporate issuance. they will presumably have more cash. does that mean there will be less issuance? kathleen: we are expecting less issuance. it also appears that tax bill favors equity over debt. debt. supply should be lighter than this year. julie: i had an interesting

conversation with brian reynolds, strategist at can accord. he talked not only about the national tax picture, for the local tax picture in the implications of rate rising local taxes for the corporate market. brian reynolds: state and local taxes went up by about $100 billion this year just for pension allocation votes. that means they didn't get 7.5% annual returns on that money. they put it into very aggressive credit funds. they put cash in the corporate balance sheet and ceo's push up their stock prices through buybacks. julie: this is an interesting concept to me that with these rising taxes at the local level the tax revenue will underpin some demand for corporate bonds. is that a phenomenon you have seen and will that continue to be a trend? julien: it could be in a critical source of demand. we think demand for high-grade corporate bonds domiciled in the u.s. will be continuing to be robust. 20 look at our yields relative to some of the other major

developed markets, certainly versus core european rates and relative to when you can get in asia, are bond market looks attractive. i would agree with what ira said. it is not really a year for beta. it applies to the investment-grade corporate bond market. we are now at the post crisis in terms of corporate on spreads. we would say you need to be focusing on industries, companies in a deleveraging mode. metals and mining they just went through a mini recession. banking we would put in that category. avoid companies that are re-leveraging, late credit cycle type of behavior. we think there is continued demand for the better parts of the corporate bond markets. julie: everyone sticking with us. kathleen gaffne, julien

scholnick and ira jersey. let's take a quick market check on what the 10-year yield did this week. we saw midweek the big drop in yields and not really a recovery after the elevated levels we had seen that were the highest since march. 2.4% is where we end the week. two-year went to 1.85%. the final spread. the week ahead features the u.s. jobs report. this is "bloomberg real yield." ♪

julie: i'm julie hyman. this is "bloomberg real yield." coming up over the next week, new year's day is monday. most global markets are closed. you have u.s. economic data, including the jobs report on

friday. plus, minutes from the last fomc meeting and the much discussed mifid ii, the biggest change to european industry rules in a decade. those are happening on wednesday. with kathleen gaffne, julien scholnick and ira jersey, and i want to focus on the jobs report on friday. we already heard a little bit about kathleen's outlook for wage growth. ira, what are you guys looking for for wage driven inflation next year? will we see any sign of that? ira: i think a little bit. one of the things i like to do is break out the cpi inflation report and a high volatility and low volatility segments. when you look at the volatility segments, a lot of service industry jobs.

the price pressures are increasing. where the energy and food related commodities and sectors that are jumping up and down in a very highly volatile, those of not rebounded to the same extent. i think inflation next year will be higher partially because of wages. julie: what are you looking at given the jobs growth we have seen, if not the wage growth we have seen? what is your expectation for the fact going into 2018? how many interest rate increases are going to get and how much is that going to matter for the treasury market? julien: right now the fed is forecasting they can raise rates three times in 2018. the market is expecting about two additional rate hikes. we think that is a relatively fair market. if we had to err on one side we would say two rather than three. this week there is some economic data. the jobs numbers. that peaked 2.8% earlier in the year which was a post crisis

high and is now closer to 2.5%. that has been the real mystery why the lower unemployment rate has not translated to higher wages. this low level of inflation which is very sluggish to move higher, that's a real conundrum. janet yellen referred to that as a mystery novel, the ultimate constraining factor for the fed. there is only so long they can ignore it. at the last meeting in december you had two dissenters. you had a bit of momentum that may be pushing back against the idea the fed can continue to hike rates with inflation as low as it is. julie: it is time for the rapid fire round. i will start with kathleen and go around the horn. does the yield curve inverted in 2018? kathleen: yes. julien: no. ira: i will take the middle ground, probably not. julie: what is the biggest risk you all are looking for in 2018? ira: i think higher inflation.

julien: i would say central-bank policy not as coordinated as it has been for the past several years. kathleen: i agree with ira. inflation coming up. julie: very quickly, new year's resolutions. kathleen: none. i don't believe in them. julien: spend as much time as i can with my 2.5-year-old daughter. ira: i want to learn to kick a soccer ball with my left foot. julie: my thanks to kathleen gaffne, julien scholnick and ira jersey. ♪

♪ julie: julie hyman and for scarlet fu. this is "bloomberg etf iq." we focus on the assets, risks, and rewards offered by traded funds. ♪ julie: 2017 saw a record year of low volatility. as we look at 2018, our guest says it will be the year of the hedge. we talked to the man behind most recent vice etf. it focused on alcohol, cannabis, and tobacco.