Stocks are at a risk of a correction if the Fed makes the right call on the economy, says Morgan Stanley

The sun may set on the bull run if the Fed is too slow cutting rates - angela weiss/Agence France-Presse/Getty Images

The big three — the S&P 500, Dow, and Nasdaq — all finished last week at yet more record highs.

Indeed, the S&P 500 is now up 33.75% from the April low, registering a 13.3% gain for the year to date as the market has become inured to White House policy uncertainty, and optimism over the AI boom continues.

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And of course there’s a more-supportive monetary policy regime, with another round of easing launched last week by the Federal Reserve.

However, a team of strategists at Morgan Stanley led by Mike Wilson sound a note of caution about the potential for market ructions should the Fed not match up to investors’ hopes.

At the moment, traders are pricing in a very high likelihood of another 50 basis points of Fed rate cuts this year from the current range of 4.00% to 4.25%. In fact, by this time next year the fed funds futures market sees the official rate around 3%.

But Wilson paints the picture of an economy that may not be in need of such aggressive rate cuts.

“Our view remains consistent that the rolling recession ended with Liberation Day and we are now transitioning to an early cycle/rolling recovery when earnings growth is likely to be stronger than expected,” he says.

This transition is being confirmed by an acceleration in earnings revisions breadth by analysts, which will dovetail with an improvement in gauges such as the ISM purchasing managers index, Wilson reckons.

“Pent-up demand is increasingly evident in areas of the economy/market that have experienced lackluster growth for the last 3-4 years. These include housing, shorter cycle industrials, consumer goods, transports, commodities, among others,” he adds.

This set up means the Fed is not as loose as it typically is at this stage of the economic cycle, Wilson feels, mainly because one part of its mandate, the labor market, hasn’t been bad enough, and the other part, inflation, is still stubbornly above the central bank’s 2% target.

“[T]his tension between the Fed’s reaction function and the markets’ ‘need for speed’ in terms of rate cuts is the near-term risk for equities and is something we’re respectful of in a weak seasonal window for performance,” says Wilson.

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Evidence that the equity market wants to see lower interest rates can be seen by the rolling correlation between equity returns and real yields, which is now deeply negative. In other words, bad economic data is deemed good for stocks.Source: Morgan Stanley -

The danger for markets is if the Fed recognizes the ‘rolling recession / recovery dynamic’ and decides they don’t need to ease that much. “Indeed, this may be the right decision economically, but the markets have already priced more cuts to come and so this would be disappointing from that standpoint and would likely prevent a full, early-cycle rotation which would lead to relative outperformance of lower quality stocks and small caps,” says Wilson.

And this may be aggravated by an environment in which liquidity is drying up as the Fed continues with its quantitative tightening — the selling of assets on its balance sheet — amid large-scale bond issuance by the Treasury and high levels of corporate debt sales.

Evidence of liquidity stress are likely to show up first in the spread between the Secured Overnight Financing Rate and Fed Funds, says Wilson. Traders should also keep an eye on the BofA Merrill Lynch MOVE index, a measure of expected Treasury volatility. A meaningful rise in the MOVE, which is currently at 72.5 and near a four-year low, may signal building Treasury market tension.Source: Morgan Stanley -

“While seemingly not a concern yet, we think liquidity stress would show up here first, and if the Fed doesn’t address this potential risk, it could lead to a sharp and meaningful equity correction,” says Wilson.

The markets

U.S. stock-indices SPX DJIA COMP are lower at the opening bell as benchmark Treasury yields BX:TMUBMUSD10Y are little changed. Silver futures SI00 trading on Nymex hit $44 an ounce for the first time in 14 years as the precious metal rallied in the wake of gold GC00, which flirted with record highs near $3,757 an ounce.

Key asset performance Last 5d 1m YTD 1y S&P 500 6664.36 1.22% 3.05% 13.31% 16.87% Nasdaq Composite 22,631.48 2.21% 5.28% 17.20% 26.09% 10-year Treasury 4.132 8.80 -14.40 -44.40 38.10 Gold 3757.4 1.02% 10.17% 42.36% 41.61% Oil 62.29 -1.56% -3.78% -13.33% -11.93% Data: MarketWatch. Treasury yields change expressed in basis points

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The buzz

A bunch of Federal Reserve officials are due to speak on Monday, including John Williams at 9:45 a.m. Eastern; Alberto Musalem at 10:00 a.m.; and Stephen Miran, Beth Hammock, and Tom Barkin, all at 12:00 p.m.

The Trump administration has imposed a $100,000 application fee on H-1B foreign worker visas, which may particularly impact technology companies.

President Trump said prominent billionaires – including media mogul Rupert Murdoch and tech founder Michael Dell – could be part of a deal in which the U.S. will take control of the social-video platform TikTok. Murdoch is the controlling shareholder of News Corp, which publishes this report.

Metsera stock MTSR jumped after a report in the Financial Times that Pfizer PFE was nearing a deal to buy the weight-loss drugmaker for $7.3 billion.

Kenvue shares KVUE are lower amid reports the Trump administration of will announce a link between its use and autism, and warn pregnant women to avoid the painkiller.

Volkswagen shares XE:VOW3 are falling sharply after the carmaker warned late Friday of a €5.1 billion hit to its operating profits this year because its sports-car division Porsche said it would delay the rollout of its electric vehicles. Porsche’s stock XE:P911 is down sharply too.

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The chart

Macro trader and Substack writer Subu Trade notes that the S&P 500’s relative strength index, a momentum gauge, by late last week had stayed above 45 for 102 days straight, one of the longest streaks in history. “In the past 60 years, the S&P was lower EVERY time 2 weeks later,” Subu says.-

Top tickers

Here were the most active stock-market tickers on MarketWatch as of 6 a.m. Eastern.

Ticker Security name TSLA Tesla NVDA Nvidia GME GameStop NIO NIO AAPL Apple PLTR Palantir Technologies OPEN Opendoor Technologies AMD Advanced Micro Devices TSM Taiwan Semiconductor Manufacturing INTC Intel

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