This Wall Street heavyweight predicts interest rates could go even lower than markets think

Morgan Stanley imagines scenarios in which the path of fed funds is even more dovish than currently projected - Getty Images/iStock

The U.S. Federal Reserve may cut rates even more sharply than the market currently assumes. That’s the opinion of Morgan Stanley’s interest-rate strategy team after their economists updated their projected scenarios between now and the end of next year.

Their baseline forecasts currently predict a 25-basis-point rate cut at this month’s meeting and similar decrements at every other meeting through December 2026. But, assessing alternative scenarios for the U.S. economy, Morgan Stanley believes the balance of their probabilities is even more dovish.

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The general interpretation of Chair Jerome Powell’s speech at Jackson Hole, Wyo., in August was for a more accommodative bias going forward, focusing more on softness in labor market data than sticky inflation readings.

Morgan Stanley’s team of economists, led by Matthew Hornbach, assessed three plausible alternative scenarios that might lead to a different path for the fed funds FF00 target rate and concluded that the probability-weighted trajectory is even lower than their present estimate.

The Wall Street bank thinks the fed funds rate could fall more swiftly than anticipated in 2025 and 2026, perhaps as low as 2.25%, but may end the period slightly higher, around 2.75%.Target fed funds range upper bound and Morgan Stanley US Economics scenarios - Source: Morgan Stanley Research estimates, Federal Reserve, Bloomberg

This additional downward impetus to rate forecasts reinforces Morgan Stanley’s confidence in a steeper yield curve (whereby longer-term rates rise faster than short). This persuades them to recommend owning long positions in U.S. 5-year BX:TMUBMUSD05Y notes, the U.S. long bond BX:TMUBMUSD30Y, steepening trades — wherein traders take long positions at the short end of the curve and short positions in instruments of longer duration  — and long positions in January 2026 fed funds futures FFF26.

The three scenarios examined in the report (published Friday and entitled “New scenarios make us even more bullish on Treasurys”) were:

Morgan Stanley’s note emphasizes, however, that traders may assign even higher probabilities to the more dovish outcomes because of recessionary risks or the Fed taking a less hawkish approach to inflation. Painting this portrait, Morgan Stanley could see market pricing for fed funds dropping 100bp lower than the terminal rate currently assumed around 3.25%.

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More dovish scenario subjective probabilities than those assigned by our economists - Source: Morgan Stanley Research estimates, Federal Reserve, Bloomberg

As we stand, bond markets are only discounting a 20% probability of the more dovish sequence of events. Hornbach and his team opine that “this is a very small number, given the growing risks to the U.S. labor market.”

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