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Fixed Income Investing in a Rising Rate Environment Paul O’Brien Agenda Why rates should rise Could I be wrong? Strategy ideas Note: The views and opinions expressed are those of the speaker at the time of the presentation and are subject to change based on market, economic and other conditions. 2 Why Rates Should Rise Interest rates follow the economy Fiscal policy pressures Debt, debt, debt Foreign inflows are not sustainable Worries about inflation Note: The views and opinions expressed are those of the speaker at the time of the presentation and are subject to change based on market, economic and other conditions. 3 Nominal GDP Growth and Bond Yields Percent 10 8 6 4 2 1987 1990 1993 1996 Annual Growth Rate of Nominal GDP Source: EcoWin. Data as of 4Q2004. 4 1999 10-Year Treasury Yield 2002 2005 6 Taylor Rule and the Funds Rate Percent 12 10 8 6 4 2 0 1986 1989 Funds Rate 1992 1995 1998 Taylor Rule Rate Source: EcoWin and Morgan Stanley Investment Management. Data as of 4Q2004. 5 2001 2004 Expected Path of Real Short-Term Rates 3m Euro Rate Less Core PCE Price Change Percent 12 10 8 6 4 2 0 -2 -4 1970 1976 Real 3m Euro Rate 1982 1988 1994 2000 Mean 1970-2004 Source: EcoWin, Bloomberg and Morgan Stanley Investment Management. Data as of January 7, 2005. 6 2004 Fiscal Policy: Big Changes Ahead Note: An aging population Rising health care costs Fewer workers per retiree The views and opinions expressed are those of the speaker at the time of the presentation and are subject to change based on market, economic and other conditions. 7 Workers (Age 20 – 64) per Retiree (Age 65+) Ratio 5 4 3 2 1 0 2000 Source: 2010 2020 2030 2040 2050 U.S. Bureau of the Census and Morgan Stanley Investment Management. Data as of 2000 Census. 8 Medical Care Cost Increases vs. Inflation Annualized 5-Year Rate of Change (%) 7 6 5 4 3 2 1 0 1990 1992 1994 PCE Medical Care Costs Source: 1996 1998 2000 Core PCE EcoWin and Morgan Stanley Investment Management. Data as of August 2004. 9 2002 2004 CBO Federal Budget Projection Historic Average Revenues and the Conservative Spending Path Percent of GDP 4 0 -4 -8 -12 -16 2000 Source: 2010 2020 2030 2040 Congressional Budget Office and Morgan Stanley Investment Management. Data as of 2003. 10 2050 Ratio of Household Debt to Income Ratio 1.3 1.1 0.9 0.7 0.5 0.3 1959 1965 1971 Total Debt Source: 1977 1983 Home Mortgage Debt EcoWin. Data as of 3Q2004. 11 1989 1995 2001 Financial Obligation Ratio Percent 19 18 17 16 15 1980 Source: 1983 1986 1992 1989 EcoWin. Data as of 3Q2004. 12 1995 1998 2001 2004 Private Sector Financial Balance (Percent of GDP) Percent 10.0 7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5 1960 Source: 1966 1972 1978 EcoWin. Data as of 3Q2004. 13 1984 1990 1996 2002 Foreign Lending and U.S. Real Interest Rates Percent Percent 60 6 50 5 40 30 4 20 3 10 0 1990 2 1992 1994 1996 1998 2000 2002 Foreign Share of Financing Gross Nonfinancial Borrowing (Left Axis) Real 10-Year Treasury Yield (Right Axis) Source: EcoWin and Morgan Stanley Investment Management. Data as of 3Q2004. 14 2004 Foreign Official Inflows Quarterly Rates Billions 175 150 125 100 75 50 25 0 -25 1994 1996 Net Foreign Official Inflow 1998 2000 2002 Current Account Financing Need Source: EcoWin. Data as of 3Q2004. 15 2004 Net U.S. International Financial Assets Market Values, Percent of GDP 10 5 0 -5 -10 -15 -20 -25 1982 Source: 1986 1990 EcoWin. Data as of 2003. 16 1994 1998 2002 The Inflation Risk Note: A political choice More slices of the pie Bailing out borrowers The views and opinions expressed are those of the speaker at the time of the presentation and are subject to change based on market, economic and other conditions. 17 Inflation History Annual Change in Core PCE Deflator Percent 10 8 6 4 2 0 1960 1965 1970 1975 1980 Source: EcoWin. Data as of November, 2004. 18 1985 1990 1995 2000 Money Growth and Inflation Percent 14 12 10 8 6 4 2 0 1966 1971 1976 1981 1986 3-Year Growth Rate of M2, Lagged 2 Years Source: EcoWin. Data as of November, 2004. 19 1991 1996 2001 2006 Annual Change in Core PCE Deflator Putting It All Together Capital crunch coming Note: China Federal deficits Private debt Asset prices will compel equilibrium Adjustment not crisis The views and opinions expressed are those of the speaker at the time of the presentation and are subject to change based on market, economic and other conditions. 20 Could I be Wrong? Growth disappointment Excess global savings A new paradigm Note: The views and opinions expressed are those of the speaker at the time of the presentation and are subject to change based on market, economic and other conditions. 21 There Is Still a Case for Bonds Note: Caution on duration Preserve capital Income Lenders: a scarce resource The views and opinions expressed are those of the speaker at the time of the presentation and are subject to change based on market, economic and other conditions. 22 Strategy Ideas A low return world TIPS are risky A flatter yield curve Defensive on spreads Non dollar exposure Note: The views and opinions expressed are those of the speaker at the time of the presentation and are subject to change based on market, economic and other conditions. 23 Understanding the Breakeven Spread Percent 4.0 Inflation Risk Premium Breakeven Spread 3.2 Expected Inflation 1.8 Real Yield (TIPS) Source: Bloomberg and Morgan Stanley Investment Management. Data as of September 24, 2004. 24 Real Yield on 10-Year TIPS Percent 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 1998 1999 2000 10-Year TIPS Yield 2001 2002 S&P 500 Dividend Yield Source: EcoWin. Data as of December, 2004. 25 2003 2004 Implied Yields on Eurodollar Futures Percent 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2005 Current 2006 2007 End-2003 Source: EcoWin. Data as of January 24, 2005. 26 2008 2009 2010 Two-Year Swap OAS to Treasuries Basis Points 100 80 60 40 20 0 1994 1996 OAS to Treasuries Source: 1998 Median (35) EcoWin. Data as of November, 2004. 27 2000 2002 2004 1-3 Year BIG Credit: OAS to Swaps Basis Points 200 150 100 50 0 1994 1996 OAS to Swaps Source: 1998 Median (34) EcoWin. Data as of November, 2004. 28 2000 2002 2004 Real Exchange Rate Indexes Index 125 115 105 95 85 75 2000 2001 Japanese Yen 2002 United States Dollar 2003 2004 2005 European Euro Source: EcoWin. Data as of December, 2004. IS04-006561-N09/04 29