jonathan: from the city of london to our viewers worldwide, i'm jonathan ferro with 30 minutes dedicated to fixed income. this is "bloomberg real yield." coming up, italian populists proposing a bigger budget. battering the italian bond market. treasuries delivering a weeks of gains, leading yields negative for european buyers. heading into q4. investment grade set for the biggest annual loss since 2008. we begin first with the big issue, populists battering the italian bond market. >> we had these rolling

existential crisis if the euro survives for years, and this is just one more stress point. >> public debt have something like 130%, which is a burden. it cannot be going even further. >> italy is a big economy in the european union. it should be a focus of concern. >> italy is still on a knife edge situation from an economic point of view. >> this has clearly been something that has been pressuring the markets for months it seems now. even if you get the budget problem out of the way now, it has not been resolved. they come back to this question in the next few months. >> there is something of a showdown that has still got to they come back to this question in the next few months. be followed through, vis-a-vis the italian government and the european union. >> this is happening right is the ecb is dialing down qe. it is going from $30 million to $15 billion and then likely zero in january. we are wondering who is going to be supporting italian debt going forward.

jonathan: joining me is diana amoa of jpmorgan, and scott thiel, deputy cio at blackrock. plus, coming to us from chicago is colin robertson, head of fixed-income at northern trust asset management. diana, i want to begin with you and talk about what is happening in italy. how big a risk is a budget deficit of 2.4% of gdp? diana: markets had been expecting something below 2%. i think the last few weeks we had numbers closer to 1.6%. 2% was really the top side the markets had been expecting. 2.4% is not a great number, particularly in the context where in the past, they have been able to meet their one-year forward projections. this time around, they don't necessarily have the tailwind from growth that they have historically had, and you have higher rates coming through as well. scott: it's important to take the number in the context of market expectation. italy had been meeting with

investors to talk about this number in particular, but more generally the italian situation overall. they guided us to a number that was closer to below 2%. i think it's about the surprise that it now is, not only for one year, but for two-year that is relevant, that it is 2.4%. keeping in mind, if you look at the most pragmatic was 1.6% and the widest was 3%, it's somewhere in the middle. at the end of the day, it's important but i think it's more about the expectations going into the announcement. jonathan: another set of expectations was the finance minister would be a moderating force. economists pointed out and quite , rightly in many people's minds, he would be that moderating force if you look at the other side of the budget discussions. is there a moderating force in the italian government? is there one left? colin: i don't think there is one left. this did surprise me, the 2.4% that came out. i think what we need to expect

is more volatility with respect to italy. what i find somewhat encouraging, though, today is the fact given this news, which was only a handful of basis points, 25 or so, that the 10-year moved up. in the context of what this was of 2.4% versus 1.9%, i found it a little bit encouraging and actually the spread versus bunds did not widen out as dramatically as i thought. i have been, at least for the near term, pleasantly surprised. jonathan: it tells you where we are on italy that 25 basis points is always a welcome move. scott: the intraday volatility is gigantic. from the last hour and a half, the 1.5 points with no volume. there was no real contagion effect throughout the capital markets today. looking at italian senior

spreads, were 15 wider. spreads were 40 wider. south african cdf's were unchanged on the day. this is not been one of these events -- it was kind of limited to italy. again, i think it is a relatively big move. if the italian bond market had taken up a high yields at the end of august, another 25 basis point from here, we might start to see that contagion. thus far, we haven't. jonathan: it is isolated to italy, which makes you wonder how mispriced bunds might be. listen to ecb commentary at the moment. they seem optimistic about the situation, the fundamentals of europe. to put a bit into bunds at the moment, you have got to believe the ecb's monetary policy stance will move from where it is currently. do you see that happening? diana: it is interesting to me. we talk about the contagion being limited, but you have to look at correlations. the euro-dollar still reacted. the moves are marginal in other sectors, but it does not mean we have not seen a slight

repricing. it is something the ecb will be watching very closely. they have to deal with the italian headache. they also have brexit around the color. for them, the policy outlook is much more modeled by this outcome than if he had the 1.9% budget number we would have. jonathan: the market is drawing a distinction between supply risk and redenomination risk. do you think the tailwind is there that we could be on the path for exploring redenomination risk in a eurozone country? colin: i don't really think we are at that point yet. i think we need to take it a couple more steps further to be a stress for the market. that type of redenomination risk, i don't think we are there. jonathan: at the moment, if you look back at the financial crisis, the eurozone debt crisis, one hangover that is still here -- investors are treating peripheral debt as if it is credit and not sovereign debt. how much of a problem is that?

colin: you end up having investors chasing the market both ways. if we look at a chart of non-european investors holding of italian bonds, they went way down as the market sold off, suggesting people were stopping themselves out of positions in august so in the market starts -- when the market starts rallying, no external investors can chase it down. that is very much a credit. if you think about the way people trade credit or emerging markets, they get stuck in that pattern. investors think about it. it trades wider than south africa. definitely treat it as a credit. the volatility is a function of the liquidity which is terrible in the futures. i mean terrible. you have this credit-like environment, for sure. jonathan: do you see this credit like environment changing around the periphery anytime soon? the ecb has pretty much done all it can to stop the redenomination risk. there is still the periphery trade to that credit. diana: i don't think that is

going to change. i think if the ecb steps back from qe, it will become worse going forward. before had the ecb as a pretty price in different buyer of debt. we no longer have that backstop. investors are left to support this market need a factor in the fact that 2.4% might not be a disaster, but it is still a deterioration in credit. but which point are you willing to take the risk when there is no sign of fiscal consolidation on the horizon? jonathan: i'm guessing you don't like the price associated with the risk right now? diana: no. jonathan: scott? scott: the other function is the bund market. the liquidity in these risk free markets has gone way down. the spread between the treasury market and the bund market has widened out dramatically. bunds have basically been unchanged. even now today, obviously stronger. if you look at the liquidity in trading volumes, they have gone way down as a qe program has been winding down. i also think there is a strange liquidity premium keeping the bund market in this lockdown

which you described earlier. jonathan: scott thiel sticking with me, alongside diana amoa of jpmorgan, and colin robertson from northern trust asset management. coming up on the program, on the auction block, amid all the concerns on italy the government is offering up some debt. this is "bloomberg real yield." ♪

♪ jonathan: i am jonathan ferro and this is "bloomberg real yield." i want to head to the auction block now where we saw another big loan sale this week. credit suisse received so much demand for a $5 billion loan that it increased the final size

by $400 million and is closing down the sales process a week early. the deal is helping to finance kkr's leveraged buyout. in the united states, despite the treasury auctioning off two and five-year notes that offer the highest yields in a decade buyers bought the two-year note , the weakest level since 2008. all those auctions were held before this week's federal reserve's decision to raise rates once again. >> the fed didn't really want to shock the markets by making as -- making much of a change at all. >> things are great right now, things are booming. the fed is reacting to that. >> assuming that the fed moves very gradually. >> there is no sign the fed

plans to pause. >> it is really a recipe to move quietly and judiciously and don't do anything radical in one way or the other. >> we actually expect we will see four rate hikes next year after another one at the end of this year, which is above what is being priced in. >> the federal open market committee will simply set policy in the best long-term interest of the country and of the economy. i think they will do their very best to ignore outside pressures. >> the economy has been doing quite well. i think that is because of the tax reform, the regulatory reform. the fed's policy about normalizing, to get back to normal is a part of that, and the markets will be working better as that continues and i hope it does. jonathan: still with me, diana amoa of jpmorgan, scott thiel of blackrock, and colin robertson, from northern trust asset management. colin, i want to begin with you. the reserve moving that word "accommodative." as the federal reserve still an accommodative federal reserve?

colin: yes, it is still an accommodative federal reserve. there are a number of important things going on here. removal of "accommodative" was investors ands more of a position, and that's what chairman powell wanted to send the message of, that the data is what is important. we know it is priced into the market and we know the expectations for the fed numbers with respect to the dot plots. i find that intriguing, too. if you look at the dots, obviously there is a move priced in here in december and three more next year. that would put us at a position at the end of 2019 at three and 1/8, and that seems high to me for the 10-year treasuries. when you look further out where the dot plots are measured, the expectation is we come to a terminal spot around 3%. even the 2021 dots are varied.

i think that when the data comes through when we see inflation stuck at low levels and moderate paces of growth, i think the likelihood of one move this year and three next year is really overblown. i think each move they make, the next one will be that much tougher. jonathan: diana, what are your thoughts on that? you can take the dots and look at the median dot to tell the story, but when you put the dots on the screen and see the spread between them all, they are all over the place. 2019e read anything into and 2020? diana: i think that is right. the fed has been hiking rates since 2015. this economic expansion is quite long in the tooth. on top of that, we have the fiscal stimulus which might potentially be rolling over next year. there is a lot of uncertainty in the outlook beyond the next 12 months is like. that will introduce uncertainty in the dots. jonathan: the federal reserve is not in the business of forecasting recessions or economic downturns. if they were, it would mean policy is in the wrong place. for the federal reserve right now, do you see them needing to respond to a downturn in

economic growth anytime soon? do you see that situation materializing? scott: no, i don't think so. i think they are in a pretty happy place. pragmatic is the way i would describe their overall position and chairman powell's presentation. as the long-term rate gets above 3%, or above a more neutral rate, they will be some reflection to how far they want to push rates. i think they are on a very preset course for the rest of this year, for sure, and into next year. it is interesting to note that basically all real rates from the five-year to the 30 year have converged to 1%. there is this concept the market is reflecting economic growth and accommodation is being withdrawn. it is interesting that the market is getting to that place. jonathan: talk to me about how you would position the long end of the treasury curve? they are huge appetites by the front end. you have this great pickup of yield in the last 12 months. when would you consider putting duration back on and going further out on the treasury curve? scott: from a long-term

fundamental perspective, it is very consistent with a flat in flattening yield curve. that would suggest the yield curve should continue to flatten on balance. in the near-term, if we look at the amount -- the fully priced-in front end of the market, the amount of tightening priced in already, it is hard to price in more than three or four rate hikes over a 12-month period. not just from a carry perspective, but from a capital appreciation perspective. the longer term trend for a flatter yield curve is entrained. the shorter maturities offer a better value. jonathan: shorter maturity from a capital returns perspective, walk me through the why. scott: the five-year almost touched 3% briefly this week. let's say you add 1.5% for very high quality diversified , diversified spreads or you add 3.5% from emerging markets. all of a sudden, you are talking a yield of 4% or 5%. if you carry that high and you have this idea that if the fed

were to become more reflective about the pace of monetary policy tightening, you have a situation where to get it 20 to 25 basis point rally. that would give you some capital appreciation. jonathan: what do you think of that trade, just quickly? colin: i would agree with that trade. per your question, jonathan, i also would be willing to put money to work in the longer end of the curve. scott's point about the short and are spot on, but there is opportunity further out the curve as well just because my view, it's a real possibility in my opinion there are two more hikes, not four expected to the end of next year. jonathan: you will stick with me. colin robertson, diana amoa and scott thiel. in the markets this week, let's get a market check for you. two's, tens, and 30's. in the treasury market, we shape up as following on the two-year. you see the bid coming in on the

back end of the tens and the 30's. just a marginal one as we get a rally to the back into this week. still ahead, the final spread and the week ahead featuring comments from the fed's jay powell and the u.s. jobs report. this is "bloomberg real yield." ♪

♪ jonathan: i am jonathan ferro. this is "bloomberg real yield." it is time for the final spread. coming up over the next week, china's financial markets closed all week due to the holidays. plus, fed chair jay powell and u.k. prime minister theresa may speak. on friday, the jobs report just around the corner as we wrap up the end of september and the third quarter. still with me from jpmorgan is diana amoa, scott thiel of blackrock, and colin robertson from northern trust asset management. let's start in london as we wrap up the quarter. this is a really interesting quarter for credit and an interesting year for credit in the united states.

ig investment-grade really underperforming. high-yield, really outperforming. what do you make of the dynamic of the u.s. credit? scott: it is interesting to note if you look at the ratings structure and the high-yield market, the lower quality, the ccc's have compressed dramatically to now bb's. emerging markets, the high-yield or sub investment-grade has really widened relative to i.g. it is the outperformance of the high-yield market that is notable that is obviously , consistent with positive economic activity, still favorable financing rates, stock buybacks, etc. but to me, that is the most surprising diversions between the high-yield part of the em market and the high-yield em market. jonathan: this is where you specialize and spend time looking at stuff. the third quarter has been brutal for emerging markets as people wake up to the idea it is not idiosyncratic and there is something broader happening here. what is your take from the third quarter as we approach the end of the year and how you should be positioning?

diana: it is interesting, and i think the point on what has been widening in em was in a few idiosyncratic names. argentina, turkey, brazil, indonesia. i think where we are at this point is, we are at a point or -- where argentina seems to be heading in the right direction with the imf coming on board and money coming through to the country sooner. turkey delivered, despite a lot of skepticism they wouldn't come through. a lot of high-yield names are actually looking a little bit better. we expect in this quarter to see some of that performance in em come through. jonathan: some of the local issues have been addressed but we still have the macro problem for emerging markets. china slowdown high yields to , the united states. can you be constructive on em right now? scott: i think you can, and those comments are spot on. we have had some high-yielders really implode. with some of the policy

responses in these countries there has been a really big , rally for the end of august in some markets. turkish two-year bonds, 11.5% yield to 5% yield. pretty big move. as investors were concerned about the backdrop and concerned about idiosyncratic risks, to some degree there is uncertainty that has been addressed. look at the fed's statement. the economy is chugging along. the chinese response to the tariff situation seems to have some sort of calming feeling. i do think it is an attractive market, but there are really some interesting opportunities in the higher yield. jonathan: i want to talk to you about whether the treasury market is attractive to the foreign buyer. when you do mention the hedges, the yield pickup is not there for treasuries, whether in europe or japan. how critical do you think that aspect is for the treasury market at the market to attract foreign buyers? colin: sure. i don't think it is overly critical. i agree with you, jonathan.

there has definitely been a shift in the valuations that make it more expensive. evidenced by the fact where long-term treasuries are right now, i think there are pivotal buyers that are happy buying treasuries and longer-term debt at these levels. it's important to have the buyers that could come in from overseas, but i don't think that is the driver and i even think as the ecb winds down the qe, it will most likely be domestic buyers that are more critical to the treasury market in the u.s. versus outside. jonathan: really thoughtful stuff, guys. we are going to end the show the way we always end the show with a rapidfire around. i get to ask three quick questions and you answer as quickly as possible. i will start with an easy one. is the federal reserve is on course to a fourth rate hike to close of the year? diana: yes. scott: yes. colin: yes. jonathan: unanimous. here is one for you. 2018, buy or hold through the end of the year.

10-year bunds or btp's? diana: btp's. scott: btp's. colin: i will take the bunds. jonathan: just quickly, does junk outperform investment great -- grade through year end in the u.s., yes or no? diana: yes, but bb's. scott: i think investment-grade outperforms. colin: high-yield outperforms. jonathan: a bit of disagreement. we make a market at the end. that you very much to diana amoa, scott thiel and colin robertson. that does it for us from london. we will be here from new york next time. this is bloomberg. ♪

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