jonathan: from new york city, worldwide, i'm jonathan ferro. bloomberg real yield starts now. coming up, u.s.-china trade talks ramp-up in washington. little sign of anything testing the federal reserve's patients anytime soon. credit grinds tighter. we begin with the big issue. is the good news baked in? is it time to start fading the rally? >> this is a good time for investors to de-risk. >> owning more cash than normal. owning more high-quality bonds.

>> time to take -- off the table. >> owning less high-yield, less levered companies. >> our tendency is to reduce credit risk over the next six to 18 months. >> there is a cap on the outside in credit. >> helping the portfolio toward high-quality, investment-grade corporate bonds. >> ultimately, you will have a pickup in defaults. >> the headwinds are the fact that the market has priced in a lot of good news. jonathan: joining me around the table is invesco advisors chief income strategist, and in london the senior investment manager at aberdeen standard investment. let's begin with you. is it time to fade to strength? it is a good question. >> the turnaround from the fed him has been so rapid, so sharp that i think it is difficult for most of us to catch breath in

terms of how quickly markets have repriced. it is big picture sense, nothing has changed. riskmeans i am cautious to assets. whether it is 6, 12, or 18 months away, i don't know. the next big move for me is going to be risk off. we are now dealing in investor psychology and the behavior of the federal reserve being very much data independent. they are not data dependent. they are on hold regardless of the data. that is the type of behavior investors rush to grab yields in that qe environment. we have seen the already. technically, i am not sure. strategically, you want to fade risk. >> looking at where we are today relative to the end of last year, you had an indication that the cycle was getting long in the tooth. you have seen a tremendous selloff in the fourth quarter and lower quality to

higher-quality. it is an opportunity to look at what you are doing in terms of high-yield, but where you are on the credit quality spectrum. >> to answer this question, you have to answer the question of how long do you think the cycle is going to be. undoubtedly growth is slower. , that is a negative. the news from the fed is that they may extend the cycle. if they are going to extend cycle, you have to only yield. you have to own that credit. you are not going to be full young. don't go short credit. jonathan: the volatility has rolled over aggressively. if you look at the index, it is remarkable how suppressed volatility has been in the treasury market. for most people, this encourages you to keep on adding risk. volatility is low. >> low volatility encourages risk-taking. low volatility is driven by the fact that the macro environment is pretty stable.

growth is slow but sufficient. there is no inflation and the system. there is next to no sign of any inflation. the term structure relatively well contained. now we have the fed, which means there is not that much to fear. that has allowed volatility to come down. jonathan: james, do you see any catalyst on the horizon that would energize volatility more than it has been the last couple of months? >> i am the same as you, jon. the fed has been successful in crushing volatility and getting us out of this artificial environment where investor psychology is one way. markets are completely asymmetric. nobody is afraid of anything. you can try every asset class with impunity. that feels completely wrong for this stage of the cycle. everybody has jumped back into the pool. i guess it does not take much to push it in the other direction.

the market yesterday was interesting. it basically said we are going to stop the balance sheet much earlier. we are unsure on rates. they are on hold. it looked like a quantitative tightening day. that tells me we are getting to that stage where everybody is rushing to the other side of the boat. i don't think it means much in terms of a trigger for us to see risk off. in this environment, without inflation spiking higher, without the threat of anything meaningful from central banks, i don't think that is going to last. jonathan: i am very sympathetic with the view of all three of you. it has quickly become the consensus view that everyone wants to fade this strength. and makes me wonder whether the pain trade is the risk rally continues. jpmorgan writes that minimal inflation, excessive capital markets, and inflation in equity markets should be supported with a continued benign credit cycle

in 2019 and beyond. jpmorgan lifting the outlook for junk bonds and beyond. >> if you look at what the fed has done, if they want to engineer anything it is a soft landing for credit markets. that feed through to equity cycles and market cycles. last year, we were looking at a fed forecasting for interest hikes. now it is essentially zero. you have removed potential tightening out of the forward outlook. that gives you support for credit markets. >> i think this cycle could go on quite a bit longer. it will continue. economic recoveries usually get killed. they don't die of their own volition. the fed is going to be more easy. they are going to pivot to a different framework and try to boost inflation, which we think there is a possibility this cycle could continue for a while. you will get paid for owning this credit.

jonathan: 400 basis points on high-yield. is that too tight? >> 7%. 430 in investment grade. those are not terrible returns in the current environment. you have had a backup in yields and spreads over the last couple of years. our message is it is a reason rate environment. you have to get credit risk with duration. if you are wrong and we come off the rails, that duration will help. jonathan: i think it is the v-shaped recovery that has people worried. do you consider them to be too tight? >> in terms of the quality of the balance sheet, the state we are in the cycle, the tools of policymakers on the fiscal and monetary side, the size of the bbb market, the overall quality spreads are too tight.

essentially we are very late , stage in the cycle. the politics we see economically in terms of the balance sheets of some of these companies is all horrible on a cyclically adjusted basis. this is a story about how many pennies you want to continue and what your time horizons are. i want to talk china. i think part of the reason we are able to keep this unstable equilibrium where we back into this qe trade is because the market has a view that chinese stimulus is going to be successful. i am not sure that is going to be the case. if it turns out to be that chinese stimulus is not working, i think that maybe the shop that knocks this out of kilter. jonathan: good point. we will discuss that later on. the question is you have to ask yourself what is the upside i am going to miss out on from de-risking? what is the answer?

>> the way we position our funds is we have to recognize that we are transitioning. we fully transitioned to a lower potential return environment. taking the foot off the gas pedal too much at the expense of getting out of what could be the next credit cycle can be extremely costly. the fed has engineered a pretty soft landing for credit markets. jonathan: coming up on the program, the auction block. big demand for inflation protection. that conversation just around the corner. we will be talking emerging markets. that is next. this is bloomberg real yields. ♪

jonathan: i am jonathan ferro. this is bloomberg real yield. i want to start with the auction block. incorporates, eli lilly's mna sale, tapping the investment grade market for $4.5 billion and offering as many as four tranches. in china, fortune land sold over half $1 billion in two-year bonds. it has been selling debt at its fastest pace in three years. the appetite for all things china and em quite remarkable.

let's pick up where we left off. the situation in china and why we are still seeing such resilient demand for some of these chinese debt issues. >> it is pretty remarkable. it is early in the process. i think hard currency, china has roughly $1 trillion of financing to do in 2019. the atmosphere post the fed's dovish turn is not surprising. i don't want to make too many judgments about how successful it is going to be throughout the year, because it is going to be drip, drip, drip. a the macroeconomic environment will play a part. i have concerns. just the share size of issuance is a concern. jonathan: the market has moved ahead of the economy.

the market and the believe that the data will come to validate the price action because the chinese stimulus will work. you have doubts about that. walk me through the doubts. >> one of the things that has happened recently is we saw a huge spike in about 5% of gdp in terms of new yuan loans in a single month. that is a massive number. it looks like some serious stimulus. in a historical context, what we see always around this time of year is a lunar new year, and there is not much access. much as we see in the fx market is you have the need to pre-fund. if you compare this with something like the chinese pmi, the bigger the drop in pmi around cheney right, the bigger -- january the bigger the spike. , this is a sign of lack of confidence. you are seeing people over

funding, making sure the corporates have enough cash through the chinese new year. the economy doesn't look strong. historically that has been a mistake. i see that is actually reflecting possibly reduced confidence and a weaker economy. i want to see more data before i can confirm that view. i don't want to jump to the conclusion that this is really the first and the step of real improvement and real increase in lending to the real economy. >> i have to agree. our position on china is two separate things going on. there is a high degree of confidence that you will see some affirmation of stability in the chinese economy in stimulus, and markets are pricing that in that there will be stimulus tools. the other one we are concerned with is sometimes we see sentiment shift. em debt is one where we see a

high degree of pickup. you are starting to see resurgence in buying into in em assets. that can be confused on the policy side. >> when we talk about china, we need to be clear. china is a big market with capital controls. they control their own destiny around the financial markets. what we know they have been doing all last year is stimulating adding stimulus to the economy. bond yields dropped, credit spreads were tightening onshore. in the last several weeks, they have continued to tighten. short end chinese interest rates are below u.s. interest rates. this tells me that the policymakers in china are very aggressively trying to support the economy. spreading that stimulus throughout the economy. that will eventually lead offshore. the ties to financial markets are a little hindered these capital controls, and it is not as directed as the old days when you had exports and imports,

economic activity. that will leak offshore. that is why they are selling these bonds. these are chinese buyers. jonathan: that is the big fear out there, the believe that the diminishing margin of return for the debt is so great that the chinese are just pushing on a string. they are pushing stimulus into the economy, and it is not biting. they have been doing this for a while. why will this work? >> the chinese economy has been rebalancing toward consumption. we have to get away from the idea that it is going to be driven by investment. in the past, china was largely driven by investment. you saw stimulus and improving investment. you put that stimulus put that into the economy, it will support consumption. we think that is happening. jonathan: what do you think of that argument?

>> i think it is an interesting argument. to some degree that is healthy. they could not go on investing at the rate they were in unproductive investment. my concern here is the stimulus we are seeing, which is consumer related, may come a bit late. all the information we are getting from onshore is there has been a massive negative shock to confidence. private enterprise and the consumers of china are feeling very concerned. when you have a savings rate which is 25%, and you add stimulus on top of a consumer that feels nervous about the growth prospects of the economy, that needs probably a high propensity to save. precautionary saving becomes a drag on the economy. you have this situation where there is stimulus going in, but it feels like it is pushing on a string on both sides.

you may be giving people money at a time when they don't want to do procyclical things with it. jonathan: how you express this in the market is the believe that the ppi trend in china at the moment is going to continue. export prices are going to come down regardless of the trade deal. the second largest economy in the world is going to continue with inflation. is that your take? >> pretty much. even if there is some growth and successful stimulus, it is going to be different. it is not to be the type of investment and commodity intensive still this we have seen in the past. that means we will have a different and less impact on the global economy. consumption will continue to push. my favorite expression of

nervousness around china is short the aussie rates market. >> we would agree with that. our position on china has been a transition from one where you are investing heavily on producer side to the consumption market. there is much more volatility in the data. that is something the market has to factor in. jonathan: it is a big debate right now. you will be sticking with me. i want to get a market check on where treasuries have been through the week. twos, tens, and 30's, the 10 year yield lower a couple basis point. down a few more on the 2-year note. 2.48%. the final spread, the week ahead, a slew of fat speakers with the spotlight on chairman jay powell. that is next. ♪

jonathan: i am jonathan ferro. this is bloomberg real yield. over the next week, president donald trump and kim jong-un meeting in vietnam. plenty of fed speakers, robert kaplan, and chairman powell delivering his semiannual report on monetary policy. still with me, rob, scott, and james. what are you looking for from the fed? >> when we look back at the fourth quarter, we knew risk assets had to have some sort of response to a higher interest rate regime. i think chairman powell might have felt he shanked that one of best a bit.

we are at 1.5% inflation. the term premium is still negative. there's not a lot of confidence in the future direction of policy. he needs to hit something more down the middle and concrete. he needs to be transparent and a little more sensitive about what financial markets are telling him in regards to risk. jonathan: for those not familiar with golf, when you set up the ball, and it goes pretty much straight in front of you. it is not pretty. have we cleaned up the communication mess? have we gone too far? have we corrected too much of the federal reserve? >> as always here in bloomberg european headquarters, they are looking after me well. i have a glass of water and a slice of humble pie to eat. last time i came on, i was very bearish treasuries.

i was very hawkish in respect to the fed. i don't think they clean up the communication. i think it is even worse. i cannot rationalize the dramatic change in policy set and guidance. this is concerning for the medium-term relationship between the economy, the federal reserve, and financial markets. you are just rewarding bad behavior. the markets have been buoyed by excessive stimulus. that money has stayed in the financial system. it is not found its way into the real economy. when the markets got wobbly, the fed came to the rescue. that is not going to encourage good behavior in the future. i continue to see a lot of speeches where there is very strange and uneasy sense of dovishness just to keep the equity market going. i can't see that's a good thing.

jonathan: you are going to stick with me for the rapidfire around. quick answers please. rate cash will stay long high-yield? >> stay long. >> raise cash. jonathan: 10-year, higher or lower? >> higher. >> higher. >> lower. jonathan: fed speak through next week, are we on hold for the rest of this year? yes or no? >> yes. >> yes. >> yes. jonathan: very insightful over the last 30 minutes. this was bloomberg real yield. ♪

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