fixed income investing in a rising rate environment paul o’brien

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

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

Fixed Income Investing in a Rising Rate Environment

Paul O’Brien

Page 2: 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.

Page 3: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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.

Page 4: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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

Page 5: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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.

Page 6: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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

Page 7: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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.

Page 8: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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

Page 9: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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 (%)

Page 10: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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

Page 11: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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

Page 12: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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

Page 13: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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

Page 14: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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

Page 15: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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

Page 16: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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

Page 17: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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.

Page 18: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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

Page 19: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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.

Page 20: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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.

Page 21: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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.

Page 22: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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.

Page 23: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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.

Page 24: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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.

Page 25: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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.

Page 26: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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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.

Page 27: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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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)

Page 28: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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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)

Page 29: Fixed Income Investing in a Rising Rate Environment Paul O’Brien

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