Is a "Dovish" Fed Imminent? Morgan Stanley Boldly Predicts: Rate Cuts May Exceed Market
Expectations!

According to Morgan Stanley's forecast, the Federal Reserve may implement larger interest rate cuts than the market currently anticipates. After updating their projection scenarios from now until the end of next year, the bank's interest rate strategy team economists arrived at this view.

Their current baseline prediction is that the Fed will cut rates by 25 basis points at this month's meeting and continue with similar cuts at every other meeting until December 2026. However, after assessing other possibilities for the U.S. economy, Morgan Stanley believes the "balance of probabilities" should lean more dovish.

Regarding Fed Chair Powell's earlier speech at the "Global Central Bankers' Annual Meeting," the market widely interpreted it as indicating that the Fed will adopt a more accommodative stance in the future, focusing more on weakness in labor market data rather than stubborn inflation data.

In a recent report, a team of Morgan Stanley economists led by Matthew Hornbach evaluated three scenarios that could lead the federal funds target rate down different paths and concluded that the weighted average interest rate path would be even lower than their current estimates.

This led them to recommend going long on U.S. 5-year Treasuries, long-term U.S. bonds, and steepener trades (where traders take long positions at the short end of the curve and short positions on longer-duration instruments), as well as going long on January 2026 federal funds futures.

However, Morgan Stanley's report emphasized that due to the risk of recession or the Fed taking a less aggressive stance on inflation, traders may view a more dovish outcome as increasingly likely. Based on this scenario, Morgan Stanley expects the market pricing of the federal funds rate could be 100 basis points lower than the currently assumed terminal rate of 3.25%.

Currently, the bond market assigns only a 20% probability to a series of more "dovish" events. Hornbach and his team stated, "Given the growing risks in the U.S. labor market, this is a very low number."