jonathan: from new york city, for our viewers worldwide, i'm jonathan ferro. this is "bloomberg real yield." coming up, treasuries gearing up for higher rates, a one-month t-bill breaking 2%. emerging-market central banks tightening policy, russia the latest to hike rates. and 10 years since the lehman collapsed. the markets have a liquidity problem? has the story of divergence become a story of convergence? >> it has been a year of divergence. >> united states and the rest of the world. >> in the u.s., we are not taking risk off quite yet. >> 2019 will be a year of

convergence. >> 3% in the second half of this year, next year, starting next year, up to 2.5%. >> we are going to see convergence. >> the u.s. economy is performing very well. >> convergence and earnings. >> the next couple of quarters still look very strong. >> convergence between tech and the rest of the market. >> and you know what, the economy looks great. jonathan: a full house with me in new york. gershon distenfeld. subadra rajappa. and krishna memani. your thoughts on the convergence/divergence argument. subadra: coming into this year, i thought yields would trade much more in line with each other, but the divergence seems to have continued. my concern is if you listen to

the ecb this week, they are pretty much on hold for a good portion of next year. qe is anticipated to end sometime by the end of this year, and what that really leaves them with is very accommodative policy. in contrast, you have the u.s. raising rates four times over the next year, which makes it very hard to time monitoring policy if the u.s. tries a slowdown for the later half of the next year. this divergence could stay on a little longer than we anticipated. gershon: i agree with that. i think it is clear the ecb will be on a slow path. we are forecasting six times until the end of 2019. in the short term, i think you might continue to see divergence. krishna: if the framework works out, convergence/divergence won't matter, all of this will go in the tank if the fed tightens six times and the ecb doesn't do anything, because the

dollar would strengthen to a level that would be unsustainable for the global economy. at the end of the day, the conversation about divergence/convergence has come down to economic fundamentals. the markets are diverging because economic fundamentals are diverging, and until they start converging, there is not going to be respite. the real question for me is, does this convergence that we are looking forward to, does it come about, but more importantly, if that convergence comes through, what? with u.s. growth slowing down, or the rest of the world growth speeding up? i think that's a very important question. jonathan: where do you answer that question? which side of the debate? krishna: i think the likelihood that emerging markets and to some extent european growth is on the back of emerging market growth, the likelihood that emerging market growth accelerates in a meaningful way at this point, unlike 2015 and 2016, is very unlikely now.

if there is going to be a convergence, it will have to come from u.s. growth slowing down. we saw no evidence of that just yet. our hope is it will manifest itself, but we will see. jonathan: let's get to the pain trades. one of the pain trades off of this convergence divergence debate has been the spread between tens, germany and the united states and it has stayed wide, wide, wide. bill gross, i spoke to earlier this year who expected this spread to narrow, reportedly with some leverage. it has not worked out. do have any confidence that's going to narrow? subadra: i think ultimately the fiscal stimulus really caught a lot of markets by surprise. you have 4% gdp growth for the third quarter and we are tracking the second quarter and a 4% for the third quarter. that led to the strengthening of the dollar as well as higher treasury yields.

treasury yields are at 3% now, and bond yields are still stuck at 40 basis points. gershon: in the short-term the story is the relative difference in economic outlooks. the u.s. is really strong. we might have a problem with the dollar rallying to the point where it's problematic for global growth, but that is not the main concern of the fed at the moment. the main concern is we are at full employment and inflation is starting to creep up. if you look at the longer term, you look at deficits that continue to be a problem in the u.s., something we probably do not talk enough about, and running very loose fiscal policy, at some point that's going to -- the chickens are going to come home to roost on that, and the dollar might actually suffer as a result of that. and europe, we can argue about the exact timing, but you have to expect rates to go up in the long run. that's also unsustainable. 45 basis points on 10-year bund yields is not sustainable. jonathan: you touched on something ray dalio talked about earlier this week. do we really face a scenario, a risk-averse scenario where treasuries are the risk-free asset that people bid for in a

drawdown in risk assets? do we really face that scenario at some point in the next couple of years? gershon: we've been arguing forever that level matters. how much can we rally starting from 3%? we saw that, we got a couple of years ago to 1.5%, and that could happen in the short-term. it's much harder to see that the long term. but yes, in the short-term, when you have stress, people are going to go to safety. safety is going to be the dollar, safety is going to be treasuries in the u.s. krishna: janet yellen said the fed should prepare themselves for a rerun of zero rate. that tells you how the policymakers are thinking. today, because of fiscal stimulus, everything looks hunky-dory in the u.s. and will probably grow at a rapid clip. but a year from today, two years from today, if that scenario plays out, the fed tightens six times in 2019, expecting u.s. growth to continue at this level is preposterous. it cannot sustain itself and the curve would be totally inverted and the dollar would be

meaningfully stronger and you have a correction everywhere. in that environment where treasury rallies and rally in a meaningful way. >> two more times this year. i don't agree with that. policymakers also say the long-term average rate should be about 3%. another six times will take us to a little bit above that. that is not necessarily unsustainable. it might be a problem for the rest of the world. the u.s. could continue to grow even at that kind of level. subadra: that's the fed raises may be once or twice this year and we go into recession 2019, 2020, got a framework. we are calling for a slowdown in the second half of next year in 2020. maybe that gets pushed out a little bit, but that's an eventuality and this is not just in our forecast. if you look at the fed forecast, they have a slowdown in growth as well in the coming years. in the forecast, they can't show you an actual slowdown or rate cut or recession, but that's kind of what the consensus seems

to be, a slowdown in two years. jonathan: 2020, i keep hearing about that. where does 2020 come from? why is that the buzzword right now? subadra: the way i look at it, we're already at the longest -- by the middle of next year, this is the longest business cycle. i'm not saying business cycle dies of old age, but you are starting to get to a point where you are reaching capacity and you are at full employment. the rates market especially is poised for protection. you are at 3% yield. the market is not ready to price in a rate cut yet. things just cannot stay that way for the foreseeable future. i think around around 2020, some things will change. jonathan: it's a shallow recovery and it could go on a lot longer than people think. krishna: absolutely, and that's our central theme. it's 2020 because it's not 2019. from a forecasting horizon standpoint, it's very

convenient. that is the flip answer. the real answer is it is contingent on the fed tightening meaningfully, that's four or six or whatever we say the number is in 2019. if they do that, the likelihood that we get into a recession increases meaningfully for 2020. having said that, my expectation still is that this ends up being a much longer cycle than any of us has ever expected for one simple reason, which is inflation hasn't manifested itself in a meaningful way, and until we see that, betting against the cycle has been a wrong bet. gershon: it's already been a longer cycle than almost any other cycle, but i think the flip answer is actually the real answer. back in 2016, we were saying that 2017 was the year. once we realized we are hopeless in forecasting in the short-term, within go ok then we have some insight a year or two from now.

we see this in many phenomenon, the maturity walls or the high-yield debt comes up every time. look two or three years out. it's a natural thing. jonathan: your basic argument is this economy can tolerate high-yield that the higher rates that krishna thinks it can't tolerate. you think the economy can tolerate higher yields and a much higher interest rate. gershon: the real fear is, i don't know if we going to have a recession in 18 months or not. the scary thing is one of these are to see growth slow at the same time inflation is creeping up. what is the fed going to do? they already said they would rather err on the side of easing too much rather than on doing too much to keep economies going. you might have to err on doing too much to stall that growth so you don't have an inflation problem. jonathan: coming up on the program, the auction block. italian bonds under pressure as the new government looks to form a budget. this is "bloomberg real yield."

♪

♪ jonathan: i'm jonathan ferro. this is "bloomberg real yield." i want to head to the auction block where the u.s. grade investment market continues to show stress. $6 billion in four tranches. in treasuries, the u.s. sold a combined $73 billion of three-year, 10 year, and 30 years securities this week, the second largest batch of those generation since 2010 in the 10-year sale.

the primary dealer award was the lowest since january. in europe amid italy's budget negotiations, options all drew and weaker demand. seven-year sale received bids worth 1.28 times the offer size. italy very much a topic of discussion at this week's ecb briefing with mario draghi, who addressed concerns over the country's new government. mr. draghi: words have created some damage. and interest rates have gone up for households and for firms. all of this hasn't created much spillover to other euro area countries. it's remained pretty much an italian episode. jonathan: still with me, gershon distenfeld, subadra rajappa, and krishna memani. for the ecb, it looks like a bit of a snooze fest. how do you think the policy path does adjust over the next 18

months? subadra: we have the ecb meeting this week, and we didn't get a whole lot of specifics on what they are going to do on the policy front that is new that we didn't already know. they're going to lower the pace of asset purchases in october. they are anticipated -- and they were very careful about their wording -- they are anticipating to end qe at the end of this year, and normalize policy sometime in the middle of next year. they are basically telling you, we are aware of what's happening in italy, but it's not really a policy concern as of yet because the rest of europe seems to be doing quite well. jonathan: what we see in european credit is different. gershon, a stat came from your team that i thought was phenomenal. u.s. high-yield has outperformed global high-yield for the most

since 2002. is that really true? gershon: it is not that big of a gap. you are just talking about corporate debt. u.s. high-yield market has done better than almost anyone would have expected. the real underperformer has been emerging markets, and we know that is a storied name. something we agree upon, that is probably where the real value is. you have to have a stomach for it because there is going to be some volatility, but that's really under performances, that's what value seems to be in the marketplace. jonathan: your argument seems to be diversify away from u.s. high-yield. gershon: it might not be right in the next month or two, but if you look at where evaluations are and where we are in the cycle in the u.s., it makes sense whether that's convergence or divergence, in your language, but essentially in all likelihood you are going to see stuff outside the u.s. over the next 12 to 18 month outperform. jonathan: that is convergence. krishna: yes, indeed, it is. i'm glad to see him talk about getting away from high-yield. him and we continue to believe -- we continue to believe the best value in credit is really in emerging markets, because

they have corrected in a meaningful, meaningful way. the spread between u.s. high-yield and emerging markets is probably the largest it has been in a long, long time. having said that, there's going to be a lot of volatility, and it will depend on the convergence working out the right way. jonathan: can we get more polarization within the em complex? that is what traders want at the moment. gershon: absolutely, and that's important. you cannot just say all of em. em is two completely different markets. for 75% of the country or so, you haven't seen that. you are talking about argentina and turkey, and to a lesser extent, brazil and russia. they are all stories there, all things that have to happen, they are all policies that have to be put in place, and the dollar is going to be a big story. jonathan: what have you been buying? give us a flavor of what you have been up to. gershon: not a lot. we went into this year positioned with quite a bit of things outside the u.s. and that has underperformed.

we probably added into it. we do think argentina is particularly interesting, and at the end of the day, there is support from the imf, you have two-year local bonds yielding 60%, and the odds of that outperforming over the next couple of years is very, very high. krishna: again, emerging markets are the best value, if you buy anything at the margin, that's where you look at value. let's be clear about one thing, that is emerging markets, not just dollar denominated debt. it's local currency, and it underperformed u.s. markets in a meaningful way across the board. e.m. fx is substantially weaker so a tremendous amount of value. jonathan: stick with me, krishna memani and subadra rajappa, and gershon distenfeld. in the markets, twos, tens, and 30's. yields higher at the front end by seven basis points. cycle highs on a two-year, 2% on a one-month bill in the treasury

market. have a think about that. up four basis points on tens, twos, and 30's. still ahead, the final spread of the week from the bank of japan and the 10th anniversary through the weekend of the collapse of lehman brothers. this is "bloomberg real yield." ♪

♪ jonathan: i'm jonathan ferro. this is "bloomberg real yield." it is time for the final spread. coming up over the next week, we will have the official 10-year anniversary of the collapse of lehman brothers. plus, we get a summit in korea and a decision from the bank of japan. and we get data from the u.s. 10 years, looking back, i want to look forward a little bit and think about how this market has changed post-crisis.

a lot of people point to illiquidity and what should be a very liquid market, treasures. has the liquidity changed in the treasury market? subadra: you really see any change in liquidities, still feels looks like a very liquid market. where things are fundamentally changed on the regulatory side, dealers like ourselves have to subject to leverage issue requirements that constrain our balance sheets. we are less willing to warehouse treasuries like we used to in the past. that is leading to a little bit of illiquidity in the market. jonathan: people point to that sleepy day on october 2014 when treasuries have this huge move out of nowhere and a lot of people think about that moment and think about what could happen on a really, really bad day when money floods into treasuries. what does october 2014 mean to you, and can you really tie back to the regulatory regime that came post crisis?

gershon: obviously, there is a lot of factors but there is no question that is an important factor. it has manifested itself more in the corporate architect. you might have an equal number of higher's and sellers, but the buyer might be walmart bonds or the seller is verizon wireless. there's often that ten-year treasury bonds, there's a buyer and seller. there is definitely much more matching of orders, but that does expose the market to, if you get one-sided trade one way or the other, you could see very sharp moves in short periods of time. krishna: the picture for liquidity really comes through in off-the-run treasuries than it does in on-the-run treasuries. there, the picture has certainly deteriorated. whether that's a bad thing for the markets, i'm not so sure. why should we be making really liquid markets on every security? how does that help us?

having said that, the point about the corporate market is a good one. the innovation of the corporate markets from a liquidity standpoint isn't the dealers and anything of that sort. it's really the etf's. etf's are providing countercyclical liquidity that you would not normally get because of the aggregation of the risk. you can get speculators to take the other side of all corporate investors looking to dump corporate bonds. corporate investors go one way, either day are buying all of them or selling all of them. normally because of the disaggregation, people have a challenge. with availability of etf's, that has simply helped in a significant way. jonathan: a final word on that shift to passive. gershon: it is important to note, a lot of credit etf's are really passive. they do have sampling, they can't buy every single bond in the market. the second thing is it's helping from a liquidity perspective. it's been a disaster for investors. you look at, particularly in high yields, they have woefully underperformed actively managed

high-yield funds. that may be true in segment of equity markets. it's the exact opposite. 85% of actively managed funds net of fees have beaten these things. jonathan: it is a really good final point. i will take the opportunity to ask you quick final questions on this program. get ready. do treasuries keep their risk-mitigating characteristics in the next downturn? yes or no? gershon: yes. subrada: yes. krishna: absolutely. jonathan: have we seen this cycle wise on treasuries versus bunds cycle wide? gershon: not even close. subrada: no. krishna: not close, but we're getting there. jonathan: i did this just for you, this final question is for

you and you don't have to play if you want to, subadra. u.s. high-yield or leverage loans? gershon: tied. u.s. high-yield by a wide margin over the next 12 months. subadra: pass. krishna: leveraged loans. jonathan: we will do that another time. subadra rajappa, gershon distenfeld, and krishna memani. from new york, that does it for us. we will see you next friday at 1:00 p.m. new york time, 6:00 p.m. in london. for our audience worldwide, this was "bloomberg real yield." this is bloomberg tv. ♪

♪ welcome to bloomberg businessweek. jason: we are inside bloomberg headquarters. trumping up, donald promised to drain the swamp in washington. tim o'brien, his biographer, shows he has done quite the opposite. m and facebook and twitter executives were there last week, promising more transparency. google founder larry