Morgan Stanley Sticks With "June Rate Cut" Forecast, Standing Alone on Wall Street in "Delaying the Rate Cut Wave"

How do AI inflation swap rates affect rate cut forecasts?

Rising oil prices reignite inflation concerns, leading to a rapid decline in Wall Street’s rate cut expectations, but Morgan Stanley chooses to go against the trend.

On March 16, according to Bloomberg, while many institutions have delayed their expectations for the Federal Reserve’s first rate cut to September or later, Morgan Stanley insists that the Fed will restart rate cuts in June and complete a second cut by September. This stance is noticeably at odds with current market pricing and peer opinions, making it a clear “minority” position on Wall Street.

Morgan Stanley’s Chief U.S. Economist Michael Gapen said during a roundtable on Monday, “We still maintain our forecast of rate cuts in June and September, though the risk is that the timing could be delayed.”

After the outbreak of war in Iran, oil prices surged sharply, and market fears of a resurgence in inflation quickly intensified. Traders significantly reduced their bets on rate cuts by the Fed this year. Meanwhile, last week, the Treasury market experienced a large-scale sell-off, with the two-year U.S. Treasury yield rising to nearly 3.75%, surpassing the Federal Reserve’s excess reserve rate — a rare occurrence.

The report notes that Michael Gapen also acknowledged that if the Fed chooses to wait until September or even December to initiate the first rate cut, the next rate cut window could be pushed back to 2027.

Morgan Stanley’s logic for sticking to the June forecast

The report states that Morgan Stanley’s core reasoning for maintaining the June rate cut forecast is its assessment of the nature of the oil price shock — viewing it as a controllable, phased external shock rather than a persistent pressure capable of fundamentally altering inflation trends.

Seth Carpenter, Morgan Stanley’s Global Chief Economist, pointed out that “the inflation spike driven by oil prices is likely only temporary.” He said, “If the oil shock becomes severe enough to start dragging down economic growth, over time, it will actually lower the potential inflation trend, especially core inflation.”

On the economic growth front, Gapen believes that current oil prices are still within the economy’s tolerable range.

“The economy can absorb oil prices of $90 to $100 per barrel. It would take sustained prices in the $125 to $150 range for a significant recession probability to develop.”

He also noted that the probability of a U.S. recession has increased from about 10% before the outbreak of military conflict to around 20%.

Morgan Stanley also emphasizes that if oil prices remain high at $125 to $150 per barrel for an extended period, it will significantly dampen consumer spending, which would then require the Fed to step in to provide support.

It is noteworthy that the market pricing and other Wall Street institutions’ expectations have shifted markedly due to the oil price shock, leading to a significant change in the outlook for Fed rate cuts.

Futures contracts linked to the Federal Funds Rate currently price in only one 25 basis point cut in December, whereas last month, the market expected at least a 50 basis point cut this year. The probability of a 25 basis point cut in September is about 60%.

The sharp volatility in the Treasury market further confirms the shift in market sentiment. Last week, the two-year Treasury yield rose to nearly 3.75%, exceeding the Fed’s excess reserve rate and breaking through a rarely breached key level.

The terminal rate, an indicator of the end point of the current easing cycle, has risen about 50 basis points since the end of February, now exceeding 3.4%.

Regarding this, Gapen said, “The rise in the two-year yield surprised me a bit. I understand the long-term rates rising, but the re-pricing of the terminal rate to such a high level was unexpected.”

Meanwhile, there is also a collective shift at the institutional level. TD Securities and Barclays last week both delayed their Fed rate cut predictions from June to September.

A key indicator: inflation swap rates

When assessing the actual impact of the oil price shock on the economy, Morgan Stanley’s Global Macro Strategist Matthew Hornbach highlighted a market indicator worth paying close attention to — the inflation swap rate.

Since crude oil prices first broke above $100 per barrel in 2022, the 1-year forward 1-year inflation swap rate has risen about 20 basis points, reaching around 2.5%.

Hornbach stated that a decline in this rate would signal buying Treasuries and pricing in more rate cuts — meaning the market’s focus is shifting from inflation concerns to demand destruction. He said:

“This is the most important indicator on your dashboard.”

This framework suggests that Morgan Stanley is not ignoring oil price risks but is using the trend in inflation swap rates as a key basis for dynamic judgment — if there are clear signals of demand deterioration, their rate cut forecast path will be adjusted accordingly.

Although Morgan Stanley maintains its baseline forecast, Gapen also clearly pointed out the downside risks: if the Fed delays the first rate cut until September or even December, the next rate cut window could be pushed back to 2027.

“The main risk to our view is that the longer the Fed waits, the more likely it is that additional rate cuts will be needed.”