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 Source: EcoWin. Data as of 4Q

5 Taylor Rule and the Funds Rate Funds RateTaylor Rule Rate Percent Source: EcoWin and Morgan Stanley Investment Management. Data as of 4Q2004.

6 Expected Path of Real Short-Term Rates Real 3m Euro Rate Mean Percent Source: EcoWin, Bloomberg and Morgan Stanley Investment Management. Data as of January 7, m 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 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 CostsCore PCE Source:EcoWin and Morgan Stanley Investment Management. Data as of August Annualized 5-Year Rate of Change (%)

10 Percent of GDP Source:Congressional Budget Office and Morgan Stanley Investment Management. Data as of CBO Federal Budget Projection Historic Average Revenues and the Conservative Spending Path

11 Ratio of Household Debt to Income Total DebtHome Mortgage Debt Source:EcoWin. Data as of 3Q2004. Ratio

12 Financial Obligation Ratio Source:EcoWin. Data as of 3Q2004. Percent

13 Private Sector Financial Balance (Percent of GDP) 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) Source:EcoWin and Morgan Stanley Investment Management. Data as of 3Q2004. Percent

15 Foreign Official Inflows Net Foreign Official Inflow Current Account Financing Need Billions Source: EcoWin. Data as of 3Q2004. Quarterly Rates

16 Source:EcoWin. Data as of Net U.S. International Financial Assets Market 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 Source: EcoWin. Data as of November, 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 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 Spread 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 Source: EcoWin. Data as of December, 2004.

26 Implied Yields on Eurodollar Futures Current End-2003 Percent Source: EcoWin. Data as of January 24, 2005.

27 Source:EcoWin. Data as of November, Two-Year Swap OAS to Treasuries Basis Points OAS to Treasuries Median (35)

28 Source:EcoWin. Data as of November, Year BIG Credit: OAS to Swaps Basis Points OAS to Swaps Median (34)

29 Real Exchange Rate Indexes Japanese YenUnited States Dollar Index Source: EcoWin. Data as of December, European Euro IS N09/04