Morgan Stanley believes the Federal Reserve may lower interest rates more than the market currently anticipates. Their prediction includes cutting rates by 25 basis points at each meeting until December 2026. There is a chance for even larger cuts depending on different economic conditions. Chair Jerome Powell’s statements at Jackson Hole indicate the Fed is more concerned about a weak labor market than inflation, suggesting a shift towards easier policies. The bank outlines three scenarios: a 10% chance of increased demand from fiscal stimulus, another 10% possibility from the Fed being more tolerant of inflation, and a 30% likelihood of a mild recession caused by trade shocks. These situations imply the fed funds rate could decline to 2.25% by 2025 and settle around 2.75%, which is lower than current market expectations.

Market Misjudgment of Federal Reserve’s Path

Morgan Stanley warns that the market may not fully understand these scenarios. They believe a lower fed funds rate is more probable, but bond markets assign only a 20% chance to this outlook, while Morgan Stanley’s stance is more negative. We think the market is misjudging the Federal Reserve’s direction, expecting fewer rate cuts than likely. Following Jerome Powell’s comments, it’s clear the Fed is focusing on the labor market’s weakness rather than just inflation, suggesting a more aggressive approach to easing. Recent economic data supports the view of a slowing economy. The August 2025 non-farm payrolls report indicated only 95,000 jobs were added, which was below expectations. Additionally, the unemployment rate rose to 4.3%. Rising jobless claims provide the Fed with a strong reason to prioritize employment. Although the latest core CPI is at 3.1%, above the target, it is trending downward, allowing the Fed some leeway. There is a notable 30% chance of a mild recession from trade disruptions, which could bring rates down to 2.25%. This risk is not adequately reflected in the bond market.

Opportunities for Derivative Traders

For those trading derivatives, this signals a chance to prepare for lower interest rates soon. Entering interest rate swaps to receive a fixed rate could be a profitable move as floating rates decrease. Additionally, taking long positions in Secured Overnight Financing Rate (SOFR) futures for 2026 might capitalize on this expected policy change. Options on Treasury futures also offer strong opportunities. Purchasing call options on 10-year Treasury note futures provides a direct way to profit from declining yields (and rising bond prices). The market’s current complacency keeps implied volatility on these options reasonable, creating an appealing risk-reward scenario. We’ve seen similar situations before, like the lead-up to the 2007 economic slowdown when markets underestimated the Fed’s readiness to cut rates. The present environment mirrors that; the probability-weighted rate path is significantly lower than current market expectations. Thus, preparing for a dovish surprise is a sensible strategy. Create your live VT Markets account and start trading now.

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