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

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  • Fixed Income Investing in a Rising Rate EnvironmentPaul OBrien

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    AgendaWhy rates should riseCould 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.

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    Why Rates Should RiseInterest rates follow the economyFiscal policy pressuresDebt, debt, debtForeign inflows are not sustainableWorries 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.

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    Nominal GDP Growth and Bond YieldsAnnual Growth Rate of Nominal GDP10-Year Treasury Yield PercentSource: EcoWin. Data as of 4Q2004.6

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    Taylor Rule and the Funds RateFunds RateTaylor Rule RatePercentSource: EcoWin and Morgan Stanley Investment Management. Data as of 4Q2004.

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    Expected Path of Real Short-Term RatesReal 3m Euro RateMean 1970-2004 PercentSource: EcoWin, Bloomberg and Morgan Stanley Investment Management. Data as of January 7, 2005.

    3m Euro Rate Less Core PCE Price Change

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    Fiscal Policy: Big Changes AheadAn aging populationRising health care costsFewer workers per retireeNote: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.

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    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

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    Medical Care Cost Increases vs. InflationPCE Medical Care CostsCore PCESource:EcoWin and Morgan Stanley Investment Management. Data as of August 2004. Annualized 5-Year Rate of Change (%)

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    CBO Federal Budget ProjectionPercent of GDPSource:Congressional Budget Office and Morgan Stanley Investment Management. Data as of 2003.Historic Average Revenues and the Conservative Spending Path

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    Ratio of Household Debt to IncomeTotal DebtHome Mortgage DebtSource:EcoWin. Data as of 3Q2004. Ratio

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    Financial Obligation RatioSource:EcoWin. Data as of 3Q2004.Percent

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

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    Foreign Lending and U.S. Real Interest RatesForeign 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. PercentPercent

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    Foreign Official InflowsNet Foreign Official InflowCurrent Account Financing Need BillionsSource: EcoWin. Data as of 3Q2004.

    Quarterly Rates

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

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    The Inflation RiskA political choiceMore slices of the pieBailing out borrowersNote: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.

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    Inflation HistoryPercentSource: EcoWin. Data as of November, 2004.Annual Change in Core PCE Deflator

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    Money Growth and Inflation3-Year Growth Rate of M2, Lagged 2 YearsAnnual Change in Core PCE Deflator PercentSource: EcoWin. Data as of November, 2004.

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    Putting It All TogetherCapital crunch comingChinaFederal deficitsPrivate debtAsset prices will compel equilibriumAdjustment not crisisNote: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.

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    Could I be Wrong?Growth disappointment Excess global savingsA new paradigmNote: 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.

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    There Is Still a Case for BondsCaution on durationPreserve capitalIncomeLenders: a scarce resourceNote: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.

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    Strategy IdeasA low return world TIPS are riskyA flatter yield curveDefensive on spreadsNon dollar exposureNote: 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.

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    Understanding the Breakeven SpreadInflation Risk PremiumExpected InflationReal Yield (TIPS)4.0PercentBreakeven Spread3.21.8Source: Bloomberg and Morgan Stanley Investment Management. Data as of September 24, 2004.

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    Real Yield on 10-Year TIPS10-Year TIPS YieldS&P 500 Dividend Yield PercentSource: EcoWin. Data as of December, 2004.

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    Implied Yields on Eurodollar FuturesCurrentEnd-2003 PercentSource: EcoWin. Data as of January 24, 2005.

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    Two-Year Swap OAS to TreasuriesSource:EcoWin. Data as of November, 2004.Basis PointsOAS to TreasuriesMedian (35)

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    1-3 Year BIG Credit: OAS to SwapsSource:EcoWin. Data as of November, 2004.Basis PointsOAS to SwapsMedian (34)

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    Real Exchange Rate IndexesJapanese YenUnited States DollarIndexSource: EcoWin. Data as of December, 2004.European EuroIS04-006561-N09/04

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