Transcript Title is Times New Roman 32 pt., line spacing .9 lines

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
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