fixed income investing in a rising rate environment

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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. Agenda. Why rates should rise Could I be wrong? Strategy ideas. - PowerPoint PPT Presentation

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Page 1: Fixed Income Investing in a Rising Rate Environment

Fixed Income Investing in a Rising Rate Environment

Paul O’Brien

Page 2: Fixed Income Investing in a Rising Rate Environment

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

Page 27: Fixed Income Investing in a Rising Rate Environment

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)

Page 28: Fixed Income Investing in a Rising Rate Environment

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)

Page 29: Fixed Income Investing in a Rising Rate Environment

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