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Fixed Income Investing in a Rising Rate Environment

Fixed Income Investing in a Rising Rate Environment. Paul O’Brien. Agenda. Why rates should rise Could I be wrong? Strategy ideas.

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Fixed Income Investing in a Rising Rate Environment

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  1. Fixed Income Investing in a Rising Rate Environment Paul O’Brien

  2. 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.

  3. 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.

  4. Nominal GDP Growth and Bond Yields Percent Annual Growth Rate of Nominal GDP 10-Year Treasury Yield 6 Source: EcoWin. Data as of 4Q2004.

  5. Taylor Rule and the Funds Rate Percent Funds Rate Taylor Rule Rate Source: EcoWin and Morgan Stanley Investment Management. Data as of 4Q2004.

  6. Expected Path of Real Short-Term Rates 3m Euro Rate Less Core PCE Price Change Percent Real 3m Euro Rate Mean 1970-2004 Source: EcoWin, Bloomberg and Morgan Stanley Investment Management. Data as of January 7, 2005.

  7. Fiscal Policy: Big Changes Ahead • An aging population • Rising health care costs • Fewer workers per retiree 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.

  8. Workers (Age 20 – 64) per Retiree (Age 65+) Ratio Source: U.S. Bureau of the Census and Morgan Stanley Investment Management. Data as of 2000 Census.

  9. Medical Care Cost Increases vs. Inflation Annualized 5-Year Rate of Change (%) PCE Medical Care Costs Core PCE Source: EcoWin and Morgan Stanley Investment Management. Data as of August 2004.

  10. CBO Federal Budget Projection Historic Average Revenues and the Conservative Spending Path Percent of GDP Source: Congressional Budget Office and Morgan Stanley Investment Management. Data as of 2003.

  11. Ratio of Household Debt to Income Ratio Total Debt Home Mortgage Debt Source: EcoWin. Data as of 3Q2004.

  12. Financial Obligation Ratio Percent Source: EcoWin. Data as of 3Q2004.

  13. Private Sector Financial Balance (Percent of GDP) Percent Source: EcoWin. Data as of 3Q2004.

  14. Foreign Lending and U.S. Real Interest Rates Percent Percent 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.

  15. Foreign Official Inflows Quarterly Rates Billions Net Foreign Official Inflow Current Account Financing Need Source: EcoWin. Data as of 3Q2004.

  16. Net U.S. International Financial Assets Market Values, Percent of GDP Source: EcoWin. Data as of 2003.

  17. The Inflation Risk • A political choice • More slices of the pie • Bailing out borrowers 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.

  18. Inflation History Annual Change in Core PCE Deflator Percent Source: EcoWin. Data as of November, 2004.

  19. Money Growth and Inflation Percent 3-Year Growth Rate of M2, Lagged 2 Years Annual Change in Core PCE Deflator Source: EcoWin. Data as of November, 2004.

  20. Putting It All Together • Capital crunch coming • China • Federal deficits • Private debt • Asset prices will compel equilibrium • Adjustment not crisis 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. 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.

  22. There Is Still a Case for Bonds • Caution on duration • Preserve capital • Income • Lenders: a scarce resource 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. 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.

  24. 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.

  25. Real Yield on 10-Year TIPS Percent 10-Year TIPS Yield S&P 500 Dividend Yield Source: EcoWin. Data as of December, 2004.

  26. Implied Yields on Eurodollar Futures Percent Current End-2003 Source: EcoWin. Data as of January 24, 2005.

  27. Two-Year Swap OAS to Treasuries Basis Points OAS to Treasuries Median (35) Source: EcoWin. Data as of November, 2004.

  28. 1-3 Year BIG Credit: OAS to Swaps Basis Points OAS to Swaps Median (34) Source: EcoWin. Data as of November, 2004.

  29. Real Exchange Rate Indexes Index Japanese Yen United States Dollar European Euro Source: EcoWin. Data as of December, 2004. IS04-006561-N09/04

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