jonathan: from new york city for our audience worldwide, bloomberg real yield starts right now. coming up, the job support gives the fed the green light. treasury yields taking out 2021 highs. looking ahead to another big inflation print. we begin with the fed gearing up to hike. >> the market is looking past the disappointment on the headline. >> we are inching close to full employment. >> 3.9% on the unemployment rate. >> the fed's dual mandate, full

employment and stable inflation. >> we are exiting very abnormal times. the fed cannot escape the inflation issue. >> they have a significant inflation problem on their hands. >> that should mean that the fed will normalize its monetary policy in response. >> nothing in the reportable change what the fed signals earlier. unfortunately, the fed is having to hurry up. jonathan: we have a fantastic lineup to close out the week. subadra rajappa, jim caron, and troy gayeski. subadra, your reaction to the labor market report earlier this morning? subadra: from an holistic perspective, a pretty good report. strong adp print, household surveys were strong. really, the headline is not that

big of a deal. you are looking at unemployment around 3.9%. the economy is at, if not close to, full employment. to me, this is a very strong, exactly what the fed needs to be able to raise policy at the march meeting. jonathan: troy gayeski, your take? troy: confirms everything we have discussed over the past month, about how perilous fixed income investing is right now, given how much duration there is to indices, how little of a rate rise it takes to destroy a significant part of your income stream. the difference now between six months ago and a year ago is that you also have eye-popping inflation numbers eating away at your principal every day. there is nothing in the report to suggest the fed will not

attempt to catch up from where they have been, behind the curve. jonathan: jim caron, speaking of the differences in the labor market, the relationship between unemployment and wages in this market is different from what we saw in the last cycle. i wonder if you can comment on that? jim: exactly. this gets to the heart of the matter. what we are talking about here effectively is the phillips curve, the measure between the unemployment rate, strength in the labor market, and wages. the key take away from this number is that wages are rising quickly. unemployment is falling. this is not the first time we have seen this, we have seen this for a couple of months in a row. even the labor market has been getting stronger, it is getting to a point where it is gaining traction and you are getting higher wage inflation. what we have to understand with the phillips curve, this is the cornerstone piece of economic

metric that is in the minds of every fed official. when they see a stronger labor market, higher wages, and that means you can pass through a higher cost, you get a higher inflation risk. many people are raising their fed funds forecast not just in terms of magnitude but also in terms of timing. many people are bringing forward the first rate hike to march. there is nothing in the report that is dovish for the fed. in fact, it is the opposite, emboldens them to be a bit more hawkish at this point. we even have to start to think about the balance sheet. jonathan: i think we are already there in many ways. subadra mentioned march. we heard from president daly earlier on this morning. she had to say the following. i would prefer to adjust the policy rate gradually and move into balance sheet reductions earlier in the cycle. i prefer not to do it simultaneously.

you can imagine adjusting the balance sheet after one or two hikes. let's talk about the sequencing, not just the timing of left off, but the sequencing that you expect after that. subadra: i think the fed is on track to raise rates at the march meeting. and then soon after, as early as june, they can think about running the balance sheet off gradually. this time around i see more complexity involved in communicating the balance sheet runoff. last time they did it, it was around $4 trillion. this time around, they have $8 trillion plus in their balance sheet, so the communication will be more challenging. they could start balance sheet runoff as early as the june eating --meeting.

i don't see them starting earlier than that. jonathan: typically when a market starts to think about a more aggressive fed, the less chance that you actually get one because they have to back away. from an investor's perspective right now, what are the chances they can engineer the kind of tightening that people are talking about? troy: if you look at this cycle, it's different from the last one. because you already have eye-popping inflation numbers, that becomes the political problem number one for the biden administration as well as the fed in terms of their dual mandate. the so-called bernanke/yellen /powell put his a little further out in the money. if the fed wants tighter conditions, they can get them. that probably means equity ends up with two or three turns of compression this year. if balance sheet runoff meets more compression, maybe

somewhere in the 20 to 30 down range for equities. the ultimate trigger to reverse that would be similar to what it was in december of 2018, when the high-yield bond market froze up. whether they can actually pull this off, time will tell. but it will be a choppy process. it is one of those unique periods where fixed income and equity risk both look unappealing. jonathan: we heard from blackrock on when neutral is right now. this is the conversation we had to get to, when neutral is on the policy rate. >> i think this fed needs to get to neutral. we are still putting liquidity into the system. i think the fed needs to get to neutral. now we are rushing to get to neutral. credit markets are in good shape. the economy is still operating at a good level. i still think you will see mid to high 4's in gdp, but then you

have a fed who will try to break this a little bit. it is a lot a bit awkward today in how you do that when inflation is accelerating. jonathan: when i heard him say that we need to get back to neutral, we all thought, what is neutral? you talked about the earlier move from the fed, possibly more hikes than anticipated. have you got any thoughts on when neutral is? jim: here is the thing, when we think about neutral, we think about a neutral policy rate, but we also have to start thinking about with the neutral balance sheet is as well. yes, the neutral policy rate is when the real fed funds rate gets to zero. we can figure out that is probably close to the terminal fed funds rate at 2.5%. that is fine. today's news is that the problem for the fed is they cannot control the back end. the way they control the back

end is by shrinking the balance sheet. let's run this in reverse. if the fed is to hike interest rates up to 2, 2 point 5%, where will the 10 year treasury be? many analysts say it cannot get much above 2%, so does that mean we have a flat or inverted yield curve in a year or two? i think the fed really has to start to think about where the balance sheet neutral level is. they have to start thinking about the runoff and the shrinking of the balance sheet, so quantitative tightening probably does not start until later this year, but that is how they get the back end rate up. we are watching the two year yield march higher. eventually, the curve will flatten. if the economic conditions are good, then the fed is not able to engineer a tightening of financial conditions, which they are trying to do, if back end yields stay low. the only way they can really do

that is by engineering the balance sheet smaller, so some form of quantitative tightening. that is the risk, and that is why bond yields are going up. nobody knows where the neutral balance sheet is. jonathan: a ton of uncertainty to work through. what you said is interesting, so clarify this. are you saying they need to use balance sheet in place of interest rate hikes, or use the balance sheet to allow them to deliver more hikes? jim: i'm saying both. delivering more rate hikes is not going to tighten financial conditions as much. what they have to do is use the balance sheet, lean on the balance sheet more. if you would ask me what i rather see the fed hike interest rates last and shrink the balance sheet more? i would say yes. i would rather see the balance sheet reduction come in place of some of the rate hikes. jacking up front and rates, all

that will do is flatten the yield curve, given how much quantitative easing there has been, how big the balance sheet is right now and how much money there is in the system, and where global yields are. long-term yields will struggle to move higher, which means every time that that hikes rates, they will be flattening the yield curve, which is not the desired outcome. i would rather see them use the balance sheet more. jonathan: subadra, i want to give you the final word. you came up with your call of 2.25 when we were some 1.50. give me your thoughts. subadra: i completely agree with what jim said. we have been writing about the need for the balance sheet unwind from late october. the yield curve right now, where the curve was, four or five rate hikes were delivered in the previous cycle. the curve is extraordinary flat

and the fed has not even delivered one rate hike. it makes sense to use a combination of rate hikes and balance sheet unwind to try to steepen out the curve as they are raising rates. in that context, given how big the balance sheet size is, we think and underappreciated risk is the balance sheet runoff and what that good due to the long end of the yield curve. if we have a tremendous amount of term premium compression, that will be rebuilt into the back end of the curve. i could see the 10 year get to 2%, 2.25 by the end of the year and even beyond, if the fed is very keen on running off its balance sheet. jonathan: fascinating stuff. coming up on the program, the auction block. the primary market reporting payrolls following a frenetic pace to kick off the new year. that conversation is next. this is bloomberg. ♪

jonathan: live from new york city, i'm jonathan ferro. this is bloomberg real yield. in europe, the primary market starting a new year at a slower pace. sovereign debt from italy and others. u.s. blue-chip companies leading the charge in the high rate debt markets, blasting through estimates with 31 deals. royal caribbean kicking off the years junk bond issuance, weekly sales approaching $6 billion. i will never understand the cruise thing. that is a conversation for another time. subadra rajappa, jim caron, troy gayeski.

subadra, i want to talk to you about the european debt market. the german 10-year yield is getting very close to zero, within five basis points. you say the treasury market will underperform what is happening in europe, germany specifically. why? subadra: that was the call in the year ahead outlook. we thought treasuries would underperform relative to bunds. it is mostly because of the differential in the policy front. the ecb will remain very cautious. a few elections coming up in italy and france. generally speaking, but they'll be focused on in the first quarter is shifting from the pandemic program to the app. the focus will be on keeping policy accommodative in the first quarter. you are seeing the exact opposite in the u.s. if anything, the fed is very

focused on trying to remove accommodations gradually by raising the balance sheet runoff. it makes sense that yields will rise and treasuries will under arm in a selloff. jonathan: troy, do you agree? troy: same old story with europe. much higher terminal growth rates, higher neutral rates, the ecb is doing qe forever. given where we are in the recovery cycle, based on every metric, whether you look at inflation, the labor market, treasuries, u.s. fixed income high-grade should underperform europe. jonathan: the ecb has a challenge that the fed does not have, italy. the federal reserve looks across one treasury market with one set of characteristics. for the ecb, it is several with different characteristics. i referred to the german bund market. if you look at italy, i don't

know if it is a credit or sovereign or a hybrid. what is it? jim: i would say a hybrid of the two. more broadly, europe has an inflation problem around energy. whereas the u.s. market may be peeking around the first quarter of this year, inflation in europe will continue to march higher due to energy prices. outside of europe, central, eastern europe, poland, hungary, czechoslovakia, the czech republic. let's talk about where inflation rates are. they are looking at cpi rates of 7, 8 sent. inflation is very high there, creeping into the eurozone, but the ecb has a very difficult time hiking interest rates aggressively because, as you point out, you have a lot of other countries and bond markets that may start to act more like a credit than a risk-free

sovereign. that could create more stress, spread widening. the ecb has its work cut out for themselves or sure. jonathan: can they ignore the inflation story? i am pleased you brought up the energy story. in europe, you have a headline of five, but core is half of that when you strip out food and energy. can they take comfort in that two .6% core rate at the ecb? jim: europe is much less of a dynamic, broadly speaking, dynamic economy. in the u.s., you can get tremendous amounts of wage growth. if the economy turns down, wages can go down. it is harder to turn wages down in europe because of the structural natures of their markets and politics. higher inflation, even if it is 2.6% at the core level, and that

doesn't rise that much, people are still paying for food and energy. the real wages will be still low. many are on fixed incomes, pension funds, pension plans. the real wage growth becomes very challenged, and that hurts consumption, which hurts gdp. once you start to have weakness in growth, that creates these credit issues you are talking about. this is a delicate balance for europe. jonathan: they are in a tough spot. when you think about what would lead the federal reserve to back off, troy, we touched on this briefly. the durability of the fed put. what it would take to back away is different this time around. can you talk more about that? the tension that could come from the equity market, from the credit market, and whether we need to see tighter financial conditions? troy: we certainly should have

some degree of tighter financial conditions. until recently, we had the loosest conditions in history but nominal gdp is 11% higher than pre-pandemic, even before the recent inflation prints, we were trending in that direction. we should have tighter financial conditions. what is so hard is doing it in a way that does not create more problems. a logical way to think about this year, assuming the fed hikes and allows the balance sheet to patiently unwind, you have that two or three terms of multiple compression equities with 10% earnings growth, down 4%, with a variance of outcomes around that. if they do get in a position where they want to get the back end up, don't want the curve to flatten further and start winding down the balance sheet more rapidly, then you get multiple turns of compression.

most importantly, the high-yield bond and levered loan markets close up. that is what spooked them in december of 2018. it wasn't the end of the world. it was when the high-yield bond market froze. that was the -- the last time it froze was in march 2009. they had to get qe going and all of those other programs. if you are trying to price in a fed put, it is deeper now than it was in 2018, because there is so much liquidity out there. keep your eyes on the credit markets. rick was saying before, delinquencies and defaults are extremely low because we are in a 5% to 8% nominal gdp environment. on the fundamental side, you are in good shape, but if you cannot

finance and roll your debt, it becomes a problem. plan on two or three terms of multiple compression. if we hit five, that is where the fed has to rethink things. if the markets cannot roll new issuance, that is another point where they have will have to freeze balance sheet reduction and then think long and hard about any additional hikes. jonathan: everyone is sticking with us. coming up next, the final spread. from new york, this is bloomberg. ♪

jonathan: live from new york city, a big week ahead. wednesday, cpi in america. your estimate so far has a seven handle. let's get straight to the rapidfire around. inflation next week, five, six, or seven handle? or you can pick any number. subadra: seven handle for the

headline. jim: i will go with a six handle. troy: hi six, low seven handle. jonathan: how many hikes this year, 1, 2, 3, 4? subadra: three. troy: four. jim: three. jonathan: bond yields, 1, 2, 3 handle two in the year? jim: 2. subadra: 2. troy: that one is easy, 2. jonathan: so boring. thank you. from new york, this was bloomberg real yield. this is bloomberg tv. ♪

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>> this is the first word news. citigroup is the first to impose

a strict vaccine mandate, telling employees to get a shot or face termination, according to a message to staff. office workers who don't comply by january 14 will be placed on unpaid leave, and our last day of employment will come at the end of the month. moderna's chief executive officers as another round of vaccine boosters will probably needed this fall, this after u.s. regulators amended the emergency authorization for moderna vaccine to allow americans to get a booster five months after receiving the initial first two shots. the supreme court cast doubt on the biden administration's rules to require vaccines for workers. in a special session, the court's conservative justices voiced skepticism about the rule which business groups and republican led states --