jonathan: from new york city for our viewers worldwide, i'm jonathan ferro. "bloomberg real yield" starts right now. ♪ jonathan: coming up, from hawkish to dovish and then totally confused. wall street grappling with fed communication. d.c. this function. -- d.c.s function disfunction. the latest market worries, shutdown politics weighing on sentiment. plus, volatility pushing investors to pull money out of u.s. loan funds and record pace. we will begin with a big issue, a market gripped by federal reserve confusion. >> chairman powell's message

yesterday was so prophetic, it was taken badly by the market. >> it was not as dovish as people thought. >> it was a dovish hike. >> not as dovish as the market had discounted 10 minutes ago. >> that is a fairly dovish signal from the fed. >> three months ago, he was talking about he was quite hawkish, and then became more dovish. yesterday he was both. >> i didn't interpret the statement today as nearly as hawkish as market participants seemed to think. >> dovish on interest rates but hawkish on the balance sheets. >> the fed actually seemed quite bullish on growth. >> he did not deliver an early christmas present. >> but became a little more dovish at the same time. >> to some extent, the point seems to be lost on the markets. >> to underscore the dovishness, the market reaction, it is going to try to be more dovish. >> in the face of all the high uncertainty, the rule should be we pause. all he had to do was say that and markets would be at ease. jonathan: joining me around the table here in new york is george gonclaves, scott kimball, and brian rehling. brian, i want to begin with you.

if the spread of interpretations are that wide, there is something wrong with the message isn't there? , brian: yeah, it is really difficult for the fed because we are approaching the end of their easing cycle. the neutral rate is a bit of a moving target. there is not consensus exactly where that is that, so it is going to be more difficult for the fed to clearly communicate exactly when and how quickly they are going to end this rate hike cycle. jonathan: scott, do you understand the reaction function at the federal reserve? scott: i would be hard-pressed to tell you that any of us really do. i think you used the word "grappling" to start the show and that is exactly what we are doing. the reality is when we look at what the fed gave us, the moving target of the neutral rate has clearly perplexed and caused a large dispersion in what investor expectations are. we were in the start of the year with a quote from chairman powell saying "we are ways away from neutral" to now saying, we are at the lower end of the neutral range. george: there is clearly confusion at the committee.

chair powell left us with a confusing message, but at the same time i don't really think they know how to appease the markets. it will be a challenge for the next year. jonathan: let's be more specific. i do not think that chair powell knows how to settle market nerves. rich clarida and john williams have a better idea of how to do it. why the chairman struggling to connect with this market? scott: i think they are going back to their comfort zone of understanding models and trying to figure out what is the neutral rate, and it will be really challenging for them. i think you got a little bit of it today with williams throwing a bone at the balance sheet. that is potentially in play, but i think there is no consensus and that is hard for the chair to deliver a strong message. jonathan: the premise of this conversation is assuming that they need to settle the market down. do they? brian: i do not think the fed is nearly as concerned about the markets as the market think they ought to be. i think that is exactly right. i think the fed is going to look at the data and it is slow to come in and relatively slow to change and there is a risk the fed is behind the curve in the

markets are looking forward. i think that is a big risk given that the fed is focused on the data here. jonathan: what do you think the biggest issue is in terms of policy, the spread between the markets on rates and the federal reserve or the spread between the federal reserve and a balance sheet that they think should be on autopilot, and many market participants who think it should not be? brian: the rate policy is by far the most important. the balance sheet policy -- i know the market is fixated on that recently, but it has not been a big focus for a while. if you look at the balance sheet, it is still really, really big. we have only just seen a little bit of decrease if you look at the big picture. i'm not sure that $50 billion a month of rolloff is a big deal. i think the rate policy is a far bigger deal. jonathan: if it even gets to the $50 billion of max rolloff. this raises the question about the rates. if it isn't just about rates are , we arguing over 25 basis

points? because that is the spread now next year. >> if we take the fed's forecast, they are telling you to the point on rate policy that they will be done with this policy in 2019. then it will transition to the broader view of what to do with the balance sheet. jonathan: george? george: they have to be careful not to overread things either. we have had a big market move, we have had bad positioning, and a shock at the end of the year. to overdo it, the fed has to be careful. i think they did the right thing. jonathan: are they going to be able to answer some very simple questions? chairman powell was asked twice, inflation is going to undershirt -- undershoot once again. why are you raising interest rates? he could not answer the question, george. it was a nightmare performance in the news conference. it was not just average.

it was terrible. everything was lined up in the statement. come on, you could have crafted a better answer to that question than the chairman of the federal reserve can. george: they are at the point where the outlook gets a little bit fuzzy. it is towards the end. no one said it was going to be easy. they are the only central bank that has actually raised rates. they got pretty far and we have to give them credit at this point. jonathan: are you ready to price a policy mistake and what does it mean to you? george: the policy mistake is more embedded in risk assets than the rates market. but the rates market has had a big adjustment. to go much further here, the curve starts to massively invert and that would be a signal of an policy struggle. jonathan: do you anticipate that? scott: our view is not that we are coming up against a policy mistake. again, to use the word "grappling" to your point on the inflation, what the fed is grappling with is this is one of the most prolonged tightening cycles they have gone through. the fed loves their models. the error terms on those models is getting very long. everything of their models says the inflation output numbers should be higher than it is. jonathan: this was the federal reserve under chairman powell

that was meant to deemphasize the models and introduce some vagueness. why are the models important again? scott: because the data dependency in the fed will never be inextricably different. jonathan: i love the idea that the federal reserve is data dependent but no one understands reaction function. the idea that they are data dependent is totally useless if you don't understand the reaction function. when are they going to do a better job explaining the reaction function? brian: i am not sure they are. i think they are focused on the models, and i think they are a deliberative slow-moving body, , and i do not think they are going to react to the markets like the markets would like to see the fed react. jonathan: after the performance of the federal reserve the last couple of weeks, are you more willing to add duration than you were before? brian: no, not yet. i still think it is still some more to this recovery. i think the yield curve, even though it is quite flat, it tells us that there is more growth to the recovery.

i think the risk-off move is overdone. i would be looking for opportunities to extend duration, but i do not think now is the right time with rates down when they are. jonathan: george, what about you? big bid coming into tens, 30's, we take out that massive short over the past couple of months that was sitting on the long end. is now the time to add duration? did we miss the pocket of opportunity? george: you missed the pocket of opportunity, and it has to be real great duration given the show is called "real yield," and that is where it is going to be. that's what is going to really cap the rule level and the rise of rates next year. on any major dips we like to buy. scott: we agree. our view is the rates rally has been a bit overcooked. the market expectation of the reaction function often needs to be realigned. the fed is going from three hikes to two in reality is a dovish outcome by federal reserve standards. jonathan: you're not going to go from three to one without the economy totally cratering. i think maybe the base case for some people is in a number of months over a number of meetings, we may well reconcile down to where the market is now.

george gonclaves, scott kimball, and brian rehling. coming up on the program, the auction block. reviewing the year in issuance. what a year it has been. that's coming up next. this is "bloomberg real yield." ♪

jonathan: i am jonathan ferro. this is "bloomberg real yield." i want to head to the auction block now and take a look at the numbers for issuance in 2018. what a year it has been, a monster year. we start with the u.s. treasury. in the calendar year, $1.3 trillion raised in net new cash.

this number dwarfing previous years. over in corporate, high-yield issuance drying up completely. year-to-date sales slowing the levels we have not seen since 2008 with massive outflows in high-yield fund. in leverage loans, a surge of roughly $800 billion in new loans issued, even as the price index tumbled to close the year. still with me, george gonclaves, scott kimball, brian rehling. george, let's start with where the issuance has come from and what it has meant to the broader market. how important was the big issuance we have seen from the treasury, and what does it mean for crowding out other asset classes? george: you took the words right out of my mouth. it has been a crowding out. there is more to come next year. if you think about the supply we had this year, it will not end. 2019, a similar story. we project lower corporate issuance largely because there is less rollovers, but equal rollovers but less overall issuance and the treasury market is taking up a lot of that space, a lot of that oxygen. jonathan: we had em central bank governors complaining about the prospect in the spring, of that

extra issuance sucking up dollar liquidity. do you still see that being a they problem in the months to come? brian: sure, it is going to continue to grow. both of the federal's office balance sheet and the treasury has to fund to meet meet the deficit, so the crowding out is a real issue. it is not going to manifest itself in terms of higher treasury yields, but it is going to manifest itself in terms of less liquidity elsewhere in the bond market. scott: i have to agree with that. the data behind treasury supply, what that means for u.s. nominal treasury rates is murky, but it -- but i would have to agree that it is occupying space that could otherwise be making its way into other risk assets. jonathan: at the turn of the year, we had all of the conditions to fuel demand for leverage loans, and we had the supply that came with it. we end the year with a lot of people in fixed income seriously questioning that universe. brian, big outflows from etf's that track leverage loans, the cash is flowing out. typically, when we talk about flows, we talk about them confirming a trend. something we have seen already.

is there any signal in this for you? brian: we have seen several periods where high-yield spreads essentially have widened out throughout this cycle. i think the question here is, does this spread, right? does it remain in the energy names and lower credit quality? obviously, we are seeing retail move out of a lot of these yielding assets that they had purchased earlier in the cycle when rates were much lower. so the question is whether this , is the beginning of the end or this is just another event in a series of events we have seen in this cycle that have impacted credit. i am not sure we know the answer yet. i think the jury is still out. scott: there is a confluence of events. if you think about the pure asset allocation perspective, a lot of money came into leverage loans. part of it to be defensive on interest rates and using it as a surrogate for shortening duration overall. but if you look at the big perspective of what is going on in the market, with this rise in

volatility, people forget about stocks or bonds or cash. it becomes, do i want cash or risk? the event is everything that is risk is going to be equally affected, but those who have seen the most unusual flows down the stretch are going to be outsized. jonathan: what is important here, doubts or the absolute level? the reason i ask is because the turn of the year when pretty much everyone hated cash, it was the moment we were about to get the real rate of change. cash was going to start increasingly returning more and more. what's interesting at the end of the year, people are starting to fall in love with cash at a time we are talking about the federal reserve pausing and the rate of return on cash ultimately leveling out. george: that's a good point. because perhaps that is also what is motivating some of the outflows, too. all of these loans are floating base loans, and any floating rate products, you would not get much more yield pickup in these products. jonathan: the reason i ask is because you will get a continual adjustment if you believe the rate of return on cash of going to carry on increasing.

at the moment, i think we can probably paint a picture where we say the rate of return on cash is probably going to stabilize through 2019. so my question essentially is, whether we have seen that adjustment now in the back end of this year, when flows have picked up aggressively enough to money market funds to adjust for the fact that cash returns a little bit more. is this still going to be a significant story next year? brian: that is a good question. i think you are right, the cash returns are going to start to level out, so that is part of it. but i do not think you can overlook the massive risk off move we have seen from investors in general and to the extent that this was a product that they were really piling into earlier this year. they were over allocated and need to adjust that to reduce the risk. jonathan: we were talking about some of the technical issues in high-yield and leveraged loans. let's talk about the fundamentals. what to the earnings look like? most people say those trends look positive through 2019.

brian: yeah, i'm sure they look good through 2019. so i do not think we will see significant falloff for the fundamentals. the question is markets discount forward-looking, so are we going to start to see a falloff out in those fundamentals in 2020 and beyond and our investors preparing for that? i think the market is overshooting. they were a little too optimistic and i think they have moved to being too pessimistic. jonathan: we have the overshoot, and the conversation i keep having week after week is whether the overshoot becomes a something bad, mispriced or otherwise, becomes reality because we get that timing and -- tightening of financial conditions that it means something to the fundamentals of the economy. the ability of corporate to come to the market and raise cash. does perception become reality? >> at this point the data science behind the economy still looks pretty good. we are still a 70% consumption -german economy. -- consumption-driven economy. data continues to trend positively. at this point, it is tough to take a read from december and

extrapolate this into a 2019 year-long event. jonathan: can it be self-filling, george? george: it could be if it goes on long enough. the timing happened at the end of the year. overall returns are down and assets are under pressure, but in the grand scheme of things, these are minor corrections versus history. we turn the calendar, cash flows come in, seasonal behaviors to market such as hopefully stabilize things. gonclaves, scott -- george gonclaves, scott kimball, and brian rehling. my guests are sticking with me. let's check on where markets have been the last full trading week of 2018. yields lower on a two-year by about nine basis points. duration kicking in, 10 basis points lower. down 12 on a 30-year. still ahead on this program, the final spread, looking ahead to the first week of 2019, including payrolls, and you will hear from the man himself, chairman powell. what a way to start the new year. that's next. this is "bloomberg real yield." ♪

jonathan: i'm jonathan ferro. this is "bloomberg real yield." time for the final spread. looking to the first week of 2019. half the people around the world are done ringing in the new year, and the big opening day for the 116th congress that could define the year politically here in the united states. we will also hear from the chairman himself, jay powell, and we will get the first payrolls report. to start the year and to close out 2018 with a look back as well. george gonclaves, scott kimball, and brian rehling. brian, lisa abramowicz and i were talking a little earlier on on bloomberg tv about conviction trades and the lack of conviction that many people have. typically, we go into a new year with a big consensus trade we

can all get our hands around, but i don't see that this year, do you? brian: not yet, but january is usually a positive month. after the beating markets have taken in december, hopefully we can find some footing and start to change the sentiment a little bit. scott: i think i agree. i think that decembers can cause you to miss an opportunity in january. if you look at the fixed income marketplace, credit spreads and durations of traded punches, but the net effect is there are opportunities to investing credit, and the high-yield index is now pushing 8%. from a valuation perspective there are reasons to be constructive. jonathan: a good point, many people have complained about the federal reserve, and i've complained about the communication. but brian, many investors sent me messages thank goodness, i've been waiting a couple of years for this. high-yield's finally starts looking like high-yield, who would've thought it? there's a lot of opportunity for some people. brian: no question, even in short-term and high-quality maturities, you see yields that are available to investors we haven't seen in over a decade.

so definitely a bit more of a buyers' market in fixed income than we have seen for quite a while. jonathan: some people look at that chart and say, i looked at 2016 and i know how that plays out. can you get that kind of turn again for the economy where you get the reaction we got in 2015 and 2016 from central banks? can we have that next year? george: not early on. i do think people are going to be surprised that q1 will probably still be decent, that he will come in probably with some trepidation and eventually we get our footing, and we see capital put to work. i agree with the other guests, but i do think it will create a situation where the fed wants to hike in march. once we get that hike, we will reset this all over again, and what will really challenge risk assets is rates will go back up again. everyone has kind of given up on rates going up again. they will go up again over the course of 2019, at least until the middle of the year. at that point we will see if we can handle those higher rates again. jonathan: what is the catalyst for higher rates? george: we talked about supply, we also have -- again, there is

peak bearishness overall. global rates are also floored. we have ecb stops. we could see a natural kind of move higher in rates as all of the supply comes in from global markets. jonathan: we had stripped back inflation expectations, and stripped down rate sector expectations as well. do you get the sense we might've gone too far? given the positioning on the long end, we had cleaned out the shorts. is there an opportunity for you, brian? brian: absolutely i think we have gone too far. the tricky thing about markets, when you think they've gone too far, they often go further. i'm not sure the pain for risk assets is over. so we might see rates go a little bit lower. but i think it is definitely and -- definitely an overshoot, expectations falling like they have an overshoot, and i would expect reversal into next year. scott: i agree on the rate. i think rates have been a bit overcooked, and our strategy has been to continue to look through it at the data underneath it. we think if you get to q1 and

q2, you see some firmness out of the consumer portions of the economy. there will be room for rates to matriculate higher. jonathan: let's wrap up the program, shall we, and get to the rapidfire round, short answers and short questions. you have to try and answer. i have been asking a few investors this through the week as we close out the year. higher or lower by year-end on the u.s. 10-year yield through 2019? higher or lower than where we are at the time we recorded this program? george, first for you. george: we haven't had a full round trip where we are now. scott: higher. brian: higher. jonathan: does the curve invert before the federal reserve hikes again, assuming none of us have any idea when the federal reserve will hike again? do you get curve inversion? we are about 10 basis points way before the federal reserve gets to hike again. george: only if we see brexit have a hard brexit. scott: with what is going on in

washington, it's tempting, but no. brian: i don't think so. no. jonathan: i did not think that brexit would be part of the story. george: it's about u.k. gilt. they drive a lot of things. jonathan: interesting. next year, outperformance in leveraged loans or u.s. high-yield? loans or u.s. high-yield? george: high-yield. scott: high-yield. brian: high-yield. jonathan: awesome consensus. guys, great to catch up with you all to end out the year. from new york, that does it for me. we will see you next friday at 1:00 p.m. new york time, 6:00 p.m. in london with a special year ahead "bloomberg real yield." this is bloomberg tv. ♪ place, the xfinity xfi gateway.

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