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, jay powell. and tighten your seatbelts as the yield curve reaches its flattest levels since 2007. it's the last trading week of the year. as the year wraps up, we review the year that was 2017. we start with the big issue, or should i say the big issues of 2017.

>> i think the fed is itching, wanting to raise rates for some time. >> i still think the reflation trade is there, but you are going to have some volatility around that. >> i think it has had an air pocket, but the reflation trade is still in place. >> we are pleased with what going on in the unemployment picture. >> job creation remains solid. >> the jobs number is a good number. >> i see the labor market as continuing to heal. >> there is room to maneuver, but we are a long way from full employment, and wage growth is a long way from where it would be if we were close to it. >> people have confidence this administration can not only get the big themes out there, but can deliver on them. >> if he wants to make everybody happy, including his base, he has to do with the real policy stuff, not just send out tweets. >> there are a few bleary eyes in london and maybe a few surprised faces. i think 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 this is a fed that has to wait to see the whites of

the eyes of inflation. >> the reach for yield is apparent in every asset class. >> we know the insatiable chase for yield continues. >> we should be watchful for, i think, excesses or buoyancy getting to a tipping point. >> i imagine janet yellen is doing cartwheels behind the scenes at how well the market has taken the whole balance sheet reduction plan and announcement. >> i think people are going to rightly interpret that the fed can move and go in december. and go two to three times next year. >> i think they would view jay powell to be continuing over the policies we have experienced over the next several years. >> the bond market has been in a trendr bowl trend -- bull right now so that has bailed out , a lot of bond investors. yields keep going down and 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 leading to something less benign? >> if equities are doing well,

credit spreads are doing well, and if the economy is doing well, i think there will be some willingness to look past the flatness of the curve. julie: joining me today in new york is kathleen gaffne, and from pasadena, california is julien scholnick, portfolio manager at western asset management, and in princeton, new jersey, is ira jersey from bloomberg intelligence. thank you all very much for joining us. obviously, there are a lot of issues we have weighed this year thus far, probably the biggest right now is the flattening of the yield curve, kathleen. so let's start there. what happens in 2018? kathleen: well i don't have a , crystal ball with me, but the flattening of the curve indicates we are in late stages of the economic cycle. i think there is a lot of fear that the next stage is recession. i'm not so concerned about that, although i do worry about the technicals.

we are seeing the curve start to normalize. so 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: and, julian, what do you make of that question? do we see some selling pressure going into 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 to the beginning of the year, the narrative was that the new administration was going to push pro-growth policies, things like tax reform, infrastructure spending, deregulatory agenda. that was going to be progrowth and ultimately pro-inflation. at western asset, we were at the view that the legislative agenda would take longer to play out. and we are concerned inflation could move lower.

over the course of the first half of the year, we saw some of that optimism begin to fade and the curve flattened pretty significantly as they realized inflation prints 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 inflation doesn't always follow the upsurge in cyclical strength like it has done traditionally. and so, that could come at some point in the future, but again you couple this inflation with , high debt loads and you end up with pretty low rates at the long end of the curve. julie: we remain with that inflation challenge. it is facing all of us and the fed, for that matter. we have got a chart that looks at inflation expectations. that versus the curve. it shows that people are not expecting much inflation out there. that continues to be the case. the blue line is the university of michigan 5-10 year inflation expectations, versus the 2-10 spread.

ira, i want to bring you into this, because that is not a picture i look at and think inflation is going to perk up in 2018. ira: inflation expectations are certainly not expected to move up. in fact in that survey, the university of michigan survey, you see that 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. and certainly markets don't think that. that is the reason why you have 10 year inflation break 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. so, you don't have a lot of variability in inflation. in order for the curve to steepen substantially, you do need those outward, out here expectations to go up and they are just not there at all. julie: ira i was reading your , outlook for next year. f i am reading correctly, -- if

i am reading correctly, you are looking at a 10 year yield of 2.56% year-end which is below consensus. is that because of the inflation outlook? what is the main factor behind that? ira: that is a big part of it. it is just that inflation expectations will be kept in check. as the federal 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 hey, five years from now, one way or the other, we will have some kind of cyclical slowdown, even lower inflation that we have today. so it is going to be hard for the long end of the curve to significantly selloff in that environment. the one caveat is what does the ecb remove does the accommodation quicker than they have already 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? if you can bring out your crystal ball for a moment. do you guys have forecasts for where 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 expectations 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: so, do 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. every day when i pick up the paper, there seems to be some shortage they are highlighting. snowplow drivers up in maine, they can't find enough of them. that is a little bit scary after having our 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 then at the other in terms

of skilled, highly skilled employees we are seeing a , shortage there as well. i think wage pressures will be moving up. julie: julian 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 does play into it? what are you protecting for the ecb 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 starting to see inflation move up slowly, albeit at a pretty gradual pace. our thought coming in was if you get this catch-up in terms of growth from the eurozone to where the u.s. is, that should be positive for the euro. we do not think that german bunds below 40 basis points make

sense in the improving growth environment in the context of a global growth environment that is improving. so the spread between 10-year german rates and 10-year rates in the u.s. is about 200 basis points. pretty wide level, a multi-decade wide level. we expect that spread to converge over time as those long end rates normalize. and in our minds, it is really mispriced or the front end of the german bund curve. 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 point or 30 year point. we don't think fundamentals, in terms of improving growth and inflation justify rates at such , low levels. julie: we will button up this part of the conversation. but there is much more. everyone is sticking around with us. kathleen gaffne, julien scholnick, and ira jersey.

and coming up the auction block. , all the talk this year about brexit did not seem to sway investors. we will tell you why, next. this is "bloomberg real yield." ♪

♪ julie: i'm julie hyman. this is "bloomberg real yield." i want to head to the auction block now. and investors are already worried about the debt ceiling in the united states. the treasury sold $45 million worth of three-month bills at the highest rate since september 28. the debt to cover ratio was the lowest since january of 2009. over in the u.k., financial institutions more than doubled sterling denominated bond sales this year to $64 billion after

slowing in the second half of 2016. and looking at your overall, it's high-yield bond market had a bumper year with record corporate sales equivalent to $115 billion. investors hunger for yield amid rock-bottom interest rates fueling demand, including for the riskiest notes. i'm back with kathleen gaffne, julien scholnick, and ira jersey. thanks to all of you 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 as though in the u.s., the high-yield market, there is not a lot of optimism if you are a high-yield investor for where it will be next year. kathleen shaking her head here. 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. i am 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. so as soon as you get a selloff, you have buyers coming into the market. at some point i believe there will be a buyers' strike, driven mainly by rates moving up. julienjulie: julien what do youk , for high-yield next year? do you see this buyers strike potentially coming as well? julien: we still think the fundamentals are constructive for a high-yield. i would agree with kathleen, that we don't think reaching for yield makes a lot of sense at this point in the business cycle. we do think it will be a year we can clip your coupon. it would be hard-pressed to see the index spread compression you saw in 2016 or 2017, but there are pockets of opportunity.

one area we like is the rising star candidates, the upper end of the high-yield spectrum. double b rated names that have a high probability of being upgraded to investment grade. 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, kind of comparing spreads right now to what we saw in the 2011-2014 cycle. so, 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: that is right. basically, we're running out of steam. i agree with the other guests. i think what is really important when spreads are this tight, and spreads can stay tight for a number of years. it is not that spreads being

tight necessarily means they have to widen and that excess returns are negative. because of that, what you have to be is very selected and very careful. so this is really an alpha market, not a beta market. you do not want to buy and the market as a whole. specificto pick your spot, whether it is individual credits or individual sectors you think that will perform better if there is a hiccup in the market. and spreads do widen a bit. julie: kathleen broaden it out , and talk about corporate debt. i'm curious how the tax cuts affect corporate issuance going into the next year. this means they are going to have presumably 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. so, supply should be lighter than this year. julie: i had an interesting conversation yesterday with brian reynolds, who is a strategists over at canaccord. he talked not only about the

national tax picture, but the local tax picture in the -- tax picture and the implications of rate rising local taxes for the corporate market. listen what he had to say. brian reynolds: state and local taxes went up by about $100 billion this year just for pension allocation votes. they need to get 7.5% annual returns on that money. so they put it into very aggressive credit funds. those funds by corporate bonds, those bonds put cash in the corporate balance sheet and ceos push up their stock prices through buybacks. julien: so, this is an interesting concept to me, julien that with these rising , taxes at the local level, the tax revenue is then going to underpin some demand for corporate bonds. is that a phenomenon you have seen and do you think that is going to continue to be a trend? julien: it could be an incremental source of demand. we think demand for high-grade corporate bonds domiciled in the -- willgoing to be

continue to be robust. when you 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, our corporate bond market looks pretty attractive. i would agree with what ira said. it is not really a year for beta. the same thing we talked about in the high-yield market also applies to the investment-grade corporate bond market. we are now at the post crisis in in terms of investment grade corporate bond spreads and this , late in the credit cycle, we would say you need to be focusing on industries, companies in a deleveraging mode. so that would be sectors like energy, metals, and mining that just went through a mini recession in 2015 and banking we 2016. would put in that category. and of what companies that are we leveraging late credit cycle , type of behavior. but we do think there is continued demand for the better parts of the corporate bond

market. julie: ok everyone sticking with , us. kathleen gaffne, julien scholnick, and ira jersey. and that's pick a quick market check on what the 10 year yield did this week because it was an interesting week. we saw midweek here that big drop in yields, and then not really a recovery after those elevated levels we had seen that were the highest since march. 2.41% is where we end the week. as for the two year yield, it did not go much of anywhere, 1.89% is where we end the week there. still ahead, the final spread. the week ahead features the u.s. jobs report of the new year. this is "bloomberg real yield." ♪

♪ julie: i'm julie hyman. this is "bloomberg real yield." it is time for the final spread. coming up over the next week, new year's day is monday. most global markets are closed.

you do have some u.s. economic data, including the jobs report for december on friday. plus, you have minutes from the last fomc meeting and the much-discussed mifid ii, the biggest change to european investment industry rules for investment in a decade. those are happening on wednesday. i am still with kathleen gaffne, julien scholnick, and ira jersey. and i want to focus on a moment 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 wage-driven inflation next year? are we going to see any sign of that? ira: i think a little bit. in fact, one of the things i like to do is break out the cpi inflation report into high volatility and low volatility segments. and when you look at low volatility segments, a lot of

them are service industry jobs. the price pressures there are increasing, where as the energy and food-related commodities and sectors that are jumping up and down and are very highly volatile. those have not rebounded to the same extent. i think inflation next year will be higher partially because of wages. julie: julianne, what are you julien 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 fed going into 2018? how many interest rate increases are we going to get and how much is that going to matter for the treasury market? julien: sure. right now, the fed is forecasting they can raise rates an additional 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 probably say two rather than three. because we do think inflation is the constraining factor. and as -- and this week, as you

point out there is is some , economic data. not just the jobs numbers, but the average hourly earnings numbers, which we like to look at. that peaked 2.8% earlier in the year, which was a post crisis high, and is now trending down, closer to 2.5%. and so that is in the real mystery why the lower unemployment rate has not translated higher wages. but 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, and we think that will be the ultimate constraining factor for the fed as they go forward. there is only so long they can ignore it. i think at the last meeting in december, you actually had two dissenters. so you had a bit of momentum , that may beginning to build that may be beginning to build and pushing back against the idea the fed can continue to hike rates with inflation as low as it is. julie: all right. it is time for the rapid fire round. i will start with kathleen and go around the horn. kathleen does the yield curve , invert in 2018? kathleen: yes. julie: julien? julien: no. julie: and ira? ira: i will take the middle

ground, probably not. [laughter] julie: ok. what is the biggest risk you all are looking for in 2018? we will go in the opposite order. ira? ira: i think higher inflation. julie: julien? julien: i would say central-bank policy that is not as coordinated as it has been for the past several years. julie: interesting. and kathleen? kathleen: i agree with ira. the fed behind the curve with inflation coming up. julie: all right. and finally on a lighter note. very quickly, new year's resolutions. kathleen? julie: none. i don't believe in them. julie: julien? julien: spend as much time as i can with my 2.5-year-old daughter. julie: good call. ira? ira: i want to learn to kick a soccer ball with my left foot. [laughter] julie: my thanks to kathleen gaffne, julien scholnick, and ira jersey. this is bloomberg. ♪

♪ >> the dow now sitting at 20,000. >> $861 million and this thing is such a cash firehose. >> janet yellen has moved the market. >> notice certain european stocks are riding the postelection wave. >> political leaders will do national campaigning on friday. and brexit'sy future being thrown into doubt. >> opec's ability to reduce the global supply glut. >> we can bring you that bank of england decision right now. >> we have seen the markets quite resilient. ♪