fixed income investing in a rising rate environment paul o’brien
TRANSCRIPT
Fixed Income Investing in a Rising Rate Environment
Paul O’Brien
2
Why rates should rise
Could I be wrong?
Strategy ideas
Agenda
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
Interest rates follow the economy
Fiscal policy pressures
Debt, debt, debt
Foreign inflows are not sustainable
Worries about inflation
Why Rates Should Rise
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
Annual Growth Rate of Nominal GDP 10-Year Treasury Yield
Percent
2
4
6
8
10
1987 1990 1993 1996 1999 2002 2005
Source: EcoWin. Data as of 4Q2004.
6
5
Taylor Rule and the Funds Rate
Funds Rate Taylor Rule Rate
Percent
0
2
4
6
8
10
12
1986 1989 1992 1995 1998 2001 2004
Source: EcoWin and Morgan Stanley Investment Management. Data as of 4Q2004.
6
Expected Path of Real Short-Term Rates
Real 3m Euro Rate Mean 1970-2004
Percent
-4-20
2468
1012
1970 1976 1982 1988 1994 2000 2004
Source: EcoWin, Bloomberg and Morgan Stanley Investment Management. Data as of January 7, 2005.
3m Euro Rate Less Core PCE Price Change
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
0
1
2
3
4
5
2000 2010 2020 2030 2040 2050
Workers (Age 20 – 64) per Retiree (Age 65+)
Source: U.S. Bureau of the Census and Morgan Stanley Investment Management. Data as of 2000 Census.
Ratio
9
Medical Care Cost Increases vs. Inflation
PCE Medical Care Costs Core PCE
0
1
2
3
4
5
6
7
1990 1992 1994 1996 1998 2000 2002 2004
Source: EcoWin and Morgan Stanley Investment Management. Data as of August 2004.
Annualized 5-Year Rate of Change (%)
10
Percent of GDP
-16
-12
-8
-4
0
4
2000 2010 2020 2030 2040 2050
Source: Congressional Budget Office and Morgan Stanley Investment Management. Data as of 2003.
CBO Federal Budget ProjectionHistoric Average Revenues and the Conservative Spending Path
11
Ratio of Household Debt to Income
Total Debt Home Mortgage Debt
0.3
0.5
0.7
0.9
1.1
1.3
1959 1965 1971 1977 1983 1989 1995 2001
Source: EcoWin. Data as of 3Q2004.
Ratio
12
Financial Obligation Ratio
15
16
17
18
19
1980 1983 1986 1989 1992 1995 1998 2001 2004
Source: EcoWin. Data as of 3Q2004.
Percent
13
Private Sector Financial Balance (Percent of GDP)
-7.5
-5.0
-2.5
0.0
2.5
5.0
7.5
10.0
1960 1966 1972 1978 1984 1990 1996 2002
Source: EcoWin. Data as of 3Q2004.
Percent
14
Foreign Lending and U.S. Real Interest Rates
Foreign Share of Financing Gross Nonfinancial Borrowing (Left Axis)
Real 10-Year Treasury Yield (Right Axis)
0
10
20
30
40
50
60
1990 1992 1994 1996 1998 2000 2002 2004
2
3
4
5
6
Source: EcoWin and Morgan Stanley Investment Management. Data as of 3Q2004.
Percent Percent
15
Foreign Official Inflows
Net Foreign Official Inflow Current Account Financing Need
Billions
-250
25
5075
100125
150175
1994 1996 1998 2000 2002 2004
Source: EcoWin. Data as of 3Q2004.
Quarterly Rates
16
-25
-20
-15
-10
-5
0
5
10
1982 1986 1990 1994 1998 2002
Source: EcoWin. Data as of 2003.
Net U.S. International Financial AssetsMarket Values, Percent of GDP
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
Percent
0
2
4
6
8
10
1960 1965 1970 1975 1980 1985 1990 1995 2000
Source: EcoWin. Data as of November, 2004.
Annual Change in Core PCE Deflator
19
Money Growth and Inflation
3-Year Growth Rate of M2, Lagged 2 Years Annual Change in Core PCE Deflator
Percent
0
2
4
6
8
10
12
14
1966 1971 1976 1981 1986 1991 1996 2001 2006
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
Growth disappointment
Excess global savings
A new paradigm
Could I be Wrong?
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
A low return world
TIPS are risky
A flatter yield curve
Defensive on spreads
Non dollar exposure
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.
24
Understanding the Breakeven Spread
Inflation Risk Premium
Expected Inflation
Real Yield (TIPS)
4.0
Percent
Breakeven Spread3.2
1.8
Source: Bloomberg and Morgan Stanley Investment Management. Data as of September 24, 2004.
25
Real Yield on 10-Year TIPS
10-Year TIPS Yield S&P 500 Dividend Yield
Percent
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
1998 1999 2000 2001 2002 2003 2004
Source: EcoWin. Data as of December, 2004.
26
Implied Yields on Eurodollar Futures
Current End-2003
Percent
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
2005 2006 2007 2008 2009 2010
Source: EcoWin. Data as of January 24, 2005.
27
0
20
40
60
80
100
1994 1996 1998 2000 2002 2004
Source: EcoWin. Data as of November, 2004.
Two-Year Swap OAS to Treasuries
Basis Points
OAS to Treasuries Median (35)
28
0
50
100
150
200
1994 1996 1998 2000 2002 2004
Source: EcoWin. Data as of November, 2004.
1-3 Year BIG Credit: OAS to Swaps
Basis Points
OAS to Swaps Median (34)
29
Real Exchange Rate Indexes
Japanese Yen United States Dollar
Index
75
85
95
105
115
125
2000 2001 2002 2003 2004 2005
Source: EcoWin. Data as of December, 2004.
European Euro
IS04-006561-N09/04