Morgan Stanley has changed its outlook, now predicting two rate cuts by the Federal Reserve before the year ends. They foresee the first cut in September and the second in December. After these cuts, Morgan Stanley expects the Federal Reserve to lower rates quarterly throughout 2026. Their target range is between 2.75% and 3.00%.

Shift in Expectations

There has been a major shift in expectations, with the forecast now indicating two rate cuts this year, starting in September. This change has already increased the CME FedWatch Tool’s prediction for a September cut from 45% to over 70% in just the last 24 hours. With the meeting just weeks away, traders need to adjust their strategies for a more dovish Federal Reserve. This outlook bodes well for stock markets, which have been stable for most of August 2025, weighed down by concerns about “higher-for-longer” rates. Traders may want to buy near-term call options on indexes like the S&P 500 to take advantage of a possible market relief rally. This renewed hope sharply contrasts with sentiments expressed after the Jackson Hole symposium just weeks ago, when the mood was more cautious. For those trading interest rates, focusing on lower yields is now key. The 2-year Treasury yield, which reacts quickly to Fed policy, has already dropped 15 basis points to 3.95% following the news. We suggest going long on December 2025 SOFR futures as a direct way to act on this expectation, as these contracts will increase in value if the market anticipates cuts.

Impact on Market Volatility

We must also think about how this affects market volatility. While the VIX is currently low near 14, we anticipate it will rise as we approach the September 20th FOMC meeting for confirmation. Buying short-dated VIX call options could be a smart way to protect against potential surprises, much like the market dip that occurred after the hawkish comments in spring 2024. This dovish shift will likely weaken the U.S. dollar, which has been strong, trading above 105 on the DXY index for the past month. We see opportunities to position for a weaker dollar against currencies where the central bank is expected to remain steady, such as the Euro. Derivative traders might consider selling DXY futures or buying at-the-money EUR/USD call options. Create your live VT Markets account and start trading now.

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