Morgan Stanley‘s interest rate strategy team has revised its projections for Federal Reserve rate cuts, anticipating a more dovish approach than the market currently reflects. The team’s baseline forecast includes a 25-basis-point cut this month, with similar reductions continuing through December 2026. However, considering alternative economic scenarios, the team believes the most likely outcome is even more accommodative.
Matthew Hornbach, who leads the Morgan Stanley economics team, analyzed three potential scenarios. These included increased demand driven by government spending, higher inflation tolerance from the Fed, and a mild recession triggered by economic disruption. Each scenario was assigned a probability, with the mild recession scenario given the highest likelihood.
The analysis suggests the Fed funds rate could fall more rapidly than previously expected in 2025 and 2026, possibly reaching as low as 2.25%. While the final rate might be slightly higher, around 2.75%, the overall trajectory points toward a more significant decline.
This revised forecast strengthens Morgan Stanley‘s belief in a steeper yield curve. Consequently, the firm recommends long positions in various U.S. Treasury securities, including 5-year and 30-year notes, along with specific steepening trades and long positions in January 2026 Fed funds futures.
Morgan Stanley‘s report highlights that market participants might assign even greater probability to the more dovish outcomes, given the potential for recession and the Fed‘s possible shift to a less aggressive stance on inflation. The firm suggests market pricing for Fed funds could fall significantly below the current terminal rate estimate of approximately 3.25%.
Currently, bond markets only reflect a relatively low probability of the more dovish scenarios. Hornbach and his team believe this probability is underestimated, particularly given emerging risks within the U.S. labor market. The team’s analysis underscores the potential for significant adjustments in market expectations regarding Federal Reserve policy. The Morgan Stanley report concludes by noting the implications of these findings for investment strategies within the fixed-income market. The research was published on Friday under the title “New scenarios make us even more bullish on Treasurys”.
Related
