Balance sheet is apparently nothing to worry about. I imagine janet yellen is doing cartwheels behind the scenes at how well the market has taken the Balance SheetReduction Plan and announcement. The fed wants this to be like watching paint dry for us. This will be very boring. It is all preannounced. It was all very transparent. There was no surprise in the announcement yesterday. And so, i think we will be watching quantitative tightening in slow motion. I think that what she is trying to do is as little as possible. She introduced tightening in monetary policy, and she was trying to do as little as possible with the dots to keep them as unchanged as they could be in the next 12 months so beyond that they can make the policy changes. The crisis is over. We still have policy levers largely at their emergency crisis determined settings. So lets return on a methodical basis the policy levers to normal so we have the ability to control our economies. Jonathan joining me around the table today is greg peters, Senior Investment officer at pgim, priya misra at td securities, and Colin Robertson head of fixed income at Northern Trust asset management. Great to have you with me. Lets start with the fed Balance Sheet. The Federal Reserve has made making policy mistake after policy mistake for decades. This cycle we seem to have extreme faith that everything is going to be ok. Is it going to be ok . Priya if we look at every rate hike in this entire cycle, it was 90 priced in two weeks before. The market didnt react this week, i think it was because it was the most widely telegraphed move. I am not convinced the market is entirely priced in. They are starting very gradually. I think it is hard to price out a year out when there is 30 billion more in treasuries per month that will be issued. The second is, we dont really know a Crucial Point that the market cannot price in, which is how will the treasury price in the fed . Will it be built issuance, in which case i can tell you there is no impact. If the market does not have that information we cannot price it in. To start out with 6 billion per month, that is something the market can handle. It is the path forward, i think the effect might build more cumulatively over time. Jonathan what are your thoughts . Greg i think the fed is trying to pull a fast one. It has to have some sort of effect. If you believe qe, the sole purpose was to tighten risk premium, to force people at the risk curve, affect a portfolio channel, then the reverse has to have some effect. It might not be one for one, but it cannot be zero. It cannot be watching paint dry. I think ultimately the fed is getting extreme cover from other Central Banks. I think that is the story. It is not the fed. It is the ecb and the boj. Jonathan and we can put that chart up. We can basically show the percentage that the Federal Reserve has of the overall stimulus pie. It has been declining as the ecb has boost stimulus and bank of japan has boost stimulus as well. That is slowly rolling over. Is that what we are seeing here . It is not the market does not care, but the ecb has given them some cover. Colin i think the ecb is giving them a lot of cover. Clearly, the balance that the Central Banks across the globe have on their Balance Sheets is significant. Even dropping 4. 5 trillion to 2. 5 trillion over the timeframe the fed is talking about, i could see why investors are relatively calm about it. Also, i think yellen clearly gave herself room such as this is not done well, the fed may just stop and decide they will go ahead and stop the case of bringing the Balance Sheet down. Priya you brought up policy mistakes, i wonder how much of that is priced into the new reaction. The fact that the market thinks this might be a policy mistake, there are a lot of clients tell me no more hikes, maybe one more, that is it. And if you really think the hiking cycle is over, then portfolio runoff must continue. I think to your point is the view that this is the unwind of the smallest ever unwind, i therefore the market doesnt price it in. I think the policy mistake issue is on the markets mind. Jonathan Something Else ive been thinking about. And i think a lot of people were. On a demandsupply basis, there should mean higher yields. But if we look at this through the prism of the central bank responsible for Inflation Expectations, we know through history when they did qe, yields rose. And you didnt look at it from a demand supply perspective, you look at it from an inflation perspective. Why is the reverse not also true . Why cant we see a Federal Reserve that unwinds the Balance Sheet, but actually, treasuries get a longer bid. Priya i can see that if it is clearly a policy mistake. I think the one way you can knew wants the argument is to look at real rates. When the fed was doing qe, real rates were declining, Inflation Expectation was rising. Nominal rates, the sum of the two actually rose in all of the cases. Look what has happened to real rates. Ever since they started the portfolio unwind, real rates have been rising. I still think they are low and can rise some more, but Inflation Expectation, there is not a lot of inflation. The fed is telling you it is a mystery, but we believe it will show up. So we are still going to unwind. Inflation expectations are a failure. They are not all that attractive and rankings are still pretty high relative to where they could be. The curve is flattening. So something is happening. If you go back to christmas of last year to today, it is a pretty big move. 136 basis points, now down to 82. That is a pretty decent sized move. The expectation is if the fed continues along this path of tightening, the curve will continue to flatten. The yield curve is giving you a signal, i think, that the fed could be slowing down the economy too much and entering a policy mistake. Jonathan sterling at 92 basis points greg has jumped on it what is the message that comes from that . Priya it is a similar idea that the long end is the Central Banks that all the longterm growth is still low. All the fed can do is move the front end up while the long end stays anchored. There are a lot of people saying is this time for a steepener because the fed is letting the portfolio runoff. I think a lot of that is going to depend on what the treasury does. If they do announce 50year bonds, i dont think there is that much demand for long end paper. I think you get a steepening of the curve. If we get tax reform or tax cut, which is actually what it is going to be that as to the deficit, and we can talk about steepening, otherwise this will be a fedled unwind without any fiscal easing. I think this curve continues to flatten. Jonathan we have a guest question. Given the mix given the fomc 2018 dots, where do you three hikes while bringing down a terminal rate where do you think the opportunity is, in the long end for term premium or the short and for more than two hikes . Colin long end. For term premium. I think as they mentioned, with respect to what the yield curve looks like with curve flattening, the fed could find themselves in a real dilemma. If the curve continues to flatten and there is the thought process of more hikes in 2018, they will have to take them off the table because they will not be able to tighten into an inversion of the curve. Jonathan what is curious, that they trimmed their inflation projection, but maintain their estimates for hikes. Of course, this conversation could be redundant once we find out who will lead to Federal Reserve and who takes over the board position. Based on what we know now, to maintain forecast for rates is kind of hard to make sense of. Greg it is until you overlay financial conditions. I dont think they are really focusing on inflation. I think they are worrying about that very little, in fact. Growth is strong, global, cyclical upswing, we know that story. But financial conditions are as elusive as we have seen them. I think they are focused on that more than the inflation picture. Jonathan that is going to lead them ultimately to make a policy mistake. Are they focused on the wrong thing . Priya that is part of it. They could continue to try to tighten financial conditions more. I wonder if it is the belief in nairu, what if arstar stay zero all of these unobservable criteria that is making them hike. What if arstar stay zero while the fed believes it is going to rise . I wonder if that results in higher rates. It goes back to gregs point. I wonder if the fact that this hawkish reaction function was also the function of them having a different reaction function because they are trying to normalize. What we are hearing from every central bank, we are trying to normalize, not tighten. At some point when they want to tighten, i wonder if then they will care about inflation a little bit more. Jonathan i think everyone is trying to understand the reaction function. And have been for quite a while. Everyone is sticking with us. We will come back with gregory peters, Colin Robertson, and priya misra. Coming up on the program, the auction block. President donald trump made waves at the u. N. This week with strong talk about north korea. The bond market has been shrugging it off. That is next. This is bloomberg real yield. Jonathan i am jonathan ferro. This is bloomberg real yield. I want to head to the auction block. Last week, we had tajikastan offering eyeopening amand from that country. This week, we had ukraine. The country received bids for three times its 3 billion it offered for the forest for the first foray into the market since russia invaded crimea in 2014. The demand for 50 year bonds was so high that it knocked almost 40 basis points off the initial guidance. Despite tensions, offshore bond sales from south korea climbing to the highest levels since 2013. That includes a 1 billion sale by Korea Development bank. And to wrap things up, the clamor for yield did not extend to south africa. The nation had to pay more to settle 10year bonds, managing to only attract 2. 1 billion in bids for the 1 billion offered. But the story of the week was in credit. Toys r us, a quick descent into bankruptcy shocked deck debt traders this week. They are asking which other retailers will struggle to harness their debt . Investors are left asking, why did no one see this coming . Still with us is priya misra, Colin Robertson, and greg peters. Greg, that chart is stunning. We traded close to par after the last 12 months, then within two weeks, we rollover to . 29 on the dollar. Why . Greg i think people were surprised by the timing. You think about the toys selling business, the peak season is heading into christmastime. I think investors were thinking they had a little more runway and they found out they didnt. I think the toys arrest story is an interesting one because it is a toys r us story is an interesting one because it is a holdover of what happened last cycle. As part of the lbo boom 2005 deal that was extremely levered. It is less of a retail story and more of a too much debt story. I think you need to bifurcate and separate those issues and not paint retail under the same brush. Jonathan and colin, we can show that. The debt servicing costs of this company was phenomenal. They were pushing half 1 billion a year in some years in the past. We can bring that up for our viewers. Is this a standalone story . I do wonder and if we know about this, i go back to the chart of the credit, why didnt people see it coming . It wasnt in the price at all. Colin right. I think people saw it coming in the sense that it was a when, not if. This was going to happen but there was a miscalculation on the timing. As greg said, the thought process was get through the Christmas Season until 2018, but clearly it was knowable, as you stated, and i think there are some other knowables out there of other companies that are overleveraged. It is not a total oneoff, but you dont throw away the old whole sector because of this issue. Greg that was a oneyear piece of paper that you showed. It was dancing between the raindrops, a little. Jonathan when you look at the cds and you and i talked about this, the bottom line is markets and investors failed to price default risk. It is not like we were trading in the 80s, we were in the high 90s. We were not pricing in anything. I just wonder why and where was asset panic . Greg it is hard to say. We saw this in the bank space with banco popular. The market seems to be more surprised by these events, but i dont think it is broadbased. I will go back, i dont think the market is categorically mispriced. I think this is an idiosyncratic issue that took the market by surprise. We have seen an increase broadly of idiosyncratic issues. But that doesnt taint the overall market. If you look at highyield, the loan rate is up 7. 5 , but the rest of the highyield market is up 2 . I think these are localized issues. It is not endemic. Jonathan lets talk about a price. We can overlay the bloomberg highyield index with highyield energy and highyield retail. There is quite a spread, 100 basis energy over the benchmark, 200 basis points over retail. But it did interest me that those two things are rolling over, getting tighter over the last month. Greg says the price is justified. Is what you are seeing on the screen justified . Colin i agree with greg. I think the market is fairly priced. As greg pointed out, you have some circumstances where maybe we have gone tighter than where than some believe in some sectors, but the bottom line is there is still a hunt for yield and still a reason to be confident in highyield. I think the prices are fair, and i actually think spreads will tighten from here. Jonathan the price is fair, is conviction high . Colin conviction is not that high. That is probably the tougher spot and the better question. I think there is nowhere else to go in some cases. The Central Banks are a big part of this. They leave investors in the market with only limited choices, and this is an area where the choice is a good one still. Jonathan from a macro picture, i wonder how Many Companies the fed is keeping in business that should not be in business . Priya right. And i might take the negative side of this. Risk reward becomes a little stretched. The bif has been talking about this for a while. They just it recently talked about the total amount of dollars that outside the u. S. And they added fx forwards on that. There is a lot of leverage here on rates rising. Not only do you have the fed and the unwind, if the ecb starts tapering, do we get a rise in rates . Maybe it is idiosyncratic and not the entire credit market, but lots of these idiosyncratic events start coming up. From a systemic basis, i think the market will get worried. Greg i think it is an excellent point. I just dont know that it is now. Ultimately, what we are worried about is that the ecb taking stimulus away but doesnt seem to be here and now. I think highyield is very different than Investment Grade. The difference of the highyield market versus the Investment Grade market is investmentgrade companies have feasted on this low yield environment. They have been issuing en masse, each year is a new record in terms of gross issuance. They are levering up. Highyield is a different story, which makes toys r us interesting, because postcrisis you have this fed leverage cap at six times that is containing the highyield Market Making it a much more rational market. Market today than what we have seen in the past. Jonathan you are sticking with us. Greg peters of the gim, Colin Robertson of Northern Trust, and priya misra of td securities. Before we go, lets get you an update on markets. The treasury market, twos, tens and 30s. Yields are higher on twoyear. The 10year the same amount. The 30year by three basis points. It is still a flatter yield curve. Still ahead, the week featuring mario draghi, janet yellen and carney next week. This is bloomberg real yield. Jonathan im jonathan ferro. This is bloomberg real yield. Time for the final spread. Coming up, and incredibly busy week. German election coming up this weekend. The Prime Minister of japan, shinzo abe might call a snap election. And then we have these big three. Mario draghi, janet yellen, and mark carney all speaking and a possible Health Care Vote in washington, d. C. To throw in there as well. Still with me is greg peters of pti and fixed income, Colin Robertson of Northern Trust, and priya misra td securities. The fed speak, is that a good thing or a bad thing . Priya given that Central Banks are driving a lot a price action, i think it is a good thing. When you have too much confusion i think there will be with the leadership at the fed. Apart from janet yellen, there are 11 other said other fed officials speaking next week. It will keep us on our toes and probably within a range, but we want to understand long end rates, inflation, what gives them confidence on inflation. I will be watching mario draghi little more. It is definitely autumn, or the fall jonathan that is the guidance. It doesnt look like they have a clue what they are going to do yet. Greg it does not look that way. The last meeting and press conference, the market interpreted that there is something to do in october. And so, i think all eyes are on him to clarify that statement even though he did not say anything. The markets are looking for him to clarify. Jonathan what is your base case for october now . Greg i think it is steady as she goes. I mean, the challenge, if you look at the inflation numbers, that are lower today, i think there are real challenges that are structural. They are running out of bonds to buy so they have to do something. I do think they may announce something, but they may extend it at the same time. I dont think they are willing to give up yet. Jonathan has janet yellen made Mario Draghis life a little more difficult executing this Balance Sheet policy story now . Colin definitely. Theres no doubt about that. I think she makes my life more difficult because within the fed we dont have any definition if they think inflation is structural or transitory. Until they come to a consensus on that, they are making draghis life difficult and all of ours, too. Jonathan the bias is still to hike. It seems to me the bias is still to maintain Interest Rates and expectations for them as they are. Are we in for a surprise the next time we get the summary of Economic Expectations . Colin i think that is possible. I wouldnt be surprised, but i would say im not sure. But given what the fed has projected theyre going to do next year, i think a lot of things need to hit on perfect cylinders for that to happen. Jonathan is it possible you get to the end of the year, and the story has changed for the fed on Inflation Expectations . Priya i think it is a little quick for them to capitulate on the entire phillips curve. If the labor market turns and we start seeing much worse, i think absolutely. A lot of faith is based on the fact that the labor market continues to tighten, but if it is still chugging along, to locate a year from now and we are not seeing inflation, i think she is taking a lot of faith in the fact that half of cpi was wireless driven. When that is out of the data and inflation is still not picking up, i wonder if the fed things thanks they are in a bit of a catch 22. They think inflation will pick up, so they want to hike, but by hiking too soon they prevent inflation from rising. Jonathan we will have to leave it there. A special thanks to greg peters of pgim, priya misra td securities, and Colin Robertson of Northern Trust asset management. That does it for us from new york. We will see next friday at 12 00 new york time. 5 00 p. M. In london. Of course, we will bring you a week full of fed speak with jockey, yellen, and carney as well. This is bloomberg real yield. Is this a phone . Or a little internet machine . 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