Despite a surge in oil prices amid renewed Middle East geopolitical tensions prompting seasoned traders in global financial markets to drastically scale back bets on the extent of benchmark interest rate cuts by the Federal Reserve and other central banks this year, Wall Street giant Morgan Stanley is maintaining its monetary policy forecast. The firm continues to project that the Fed will resume cutting rates in June, followed by another reduction in September. In contrast, interest rate futures traders have adopted a more cautious stance due to "stagflation" fears fueled by the oil price spike. Pricing from the CME FedWatch Tool indicates widespread expectations for just one rate cut this year, significantly pushed back to September from earlier anticipations of a move in the first half.
"We maintain our call for Fed rate cuts in June and September, though the risk is that it could indeed be delayed further," said Michael Gapen, Chief US Economist at Morgan Stanley, during a roundtable discussion in New York on Monday. This forecast runs counter to current pricing in interest rate futures markets and appears more dovish compared to projections from some Wall Street peers. Firms like Goldman Sachs have already delayed their forecast for the Fed's first rate cut to September.
The rapid rise in oil prices following conflict involving Iran threatens to rekindle inflationary pressures, potentially hindering the Fed's ability to ease monetary policy further. Consequently, markets have rapidly pared back rate cut expectations and begun pricing in the possibility of "stagflation"—a scenario combining high inflation and stagnant growth—affecting the US and global economies due to soaring energy costs. For the Fed and other major central banks, stagflation represents one of the most challenging long-term macroeconomic dilemmas.
Current pricing in interest rate futures linked to the Fed's policy rate suggests only a 25-basis-point cut by December, with a 60% probability of a cut in September. This marks a significant cooling from market expectations just a month ago, which anticipated at least 50 basis points of easing. Economists at TD Securities and Barclays recently shifted their forecasts for the first Fed cut from June to September.
As shown in the accompanying chart, market pricing for Fed rate cuts by year-end has substantially moderated compared to last month, with swap markets indicating an expectation of just a 25-basis-point reduction by December.
Stagflation concerns continue to disrupt market pricing. Two key US inflation readings from the past week delivered the same message: inflation remains stubbornly above the Fed's 2% target. Combined with the recent sharp increase in international oil prices due to Middle East tensions, global investors are growing increasingly worried about the emergence of stagflation. This explains the significant recent rise in yields on the 10-year US Treasury note, often called the "anchor" for global asset pricing, as well as on the more policy-sensitive 2-year note.
As rate cut expectations diminished substantially last week, the US Treasury market experienced a significant sell-off, driving the 2-year yield close to 3.75%—above the interest rate the Fed pays on reserves, a level that is rarely breached. A market-based proxy for the "terminal rate," indicating where the Fed is expected to finish the current easing cycle, has risen by about 50 basis points since late February to over 3.4%.
"I'm a little surprised that the 2-year yield has moved up as much as it has. I can understand, perhaps, that long-end rates would go higher, but I'm still surprised that the terminal rate has been repriced so high," Gapen remarked in an interview.
Gapen acknowledged the possibility that the Fed could delay the first rate cut until September, or even December, with either scenario potentially pushing the subsequent cut into 2027. While Morgan Stanley maintains its baseline forecast, Gapen clearly identified the downside risk: the later the Fed initiates cutting, and the longer it waits, the more additional easing it might ultimately need to implement.
Market observers widely fear the US could enter a period of stagflation. Oil prices have risen 50% over the past month, inflation remains elevated, the US lost 92,000 jobs in February, and data released Friday showed fourth-quarter GDP cooled more than expected. Against this stagflationary backdrop, commentary this week from the Fed and other major central banks on monetary policy and the economic outlook becomes critically important. The Fed, European Central Bank, Bank of England, and Bank of Japan are all set to announce policy decisions, with markets closely watching for any convergence in the Fed's "dot plot" towards fewer cuts and for clues on a potential Bank of Japan rate hike. Central banks in Australia, Indonesia, and Brazil will also communicate, presenting a significant test for foreign exchange and bond markets.
Probability of Recession Rises Amid Oil Price Shock Brent crude closed above $100 per barrel for a third consecutive session, its longest streak above that level since August 2022. Investors are weighing signs of ample short-term supply against the rising threat of military strikes on energy infrastructure in the Middle East. In volatile trading on Monday, the global benchmark Brent fell 2.8% to settle at $100, while West Texas Intermediate (WTI) crude settled at $93.50 per barrel.
Morgan Stanley stated in a recent report that if energy prices remain in a range of $125 to $150 for an extended period, it would significantly drag on consumer spending and necessitate support from the Fed. According to Gapen, the probability of a US recession has risen to about 20%, up from 10% before the onset of recent military conflicts.
"The economy can handle oil at $90 to $100 a barrel. But you could certainly see oil sustained in the $125 to $150 range, which would correspond to a reasonable probability of recession," he said.
A Key Indicator for Investors to Watch Seth Carpenter, Morgan Stanley's Global Chief Economist, said at a separate event that the oil-driven inflation surge is likely to be temporary. "If things get bad enough that they start to hit growth, then over time, that actually puts further downward pressure on the underlying inflation trend, particularly core inflation," he stated.
Matthew Hornbach, Global Head of Macro Strategy at Morgan Stanley, suggested that the "inflation swap" rate is a key indicator to gauge how much high oil prices are suppressing demand. Since crude prices jumped above $100 a barrel for the first time since 2022, the 1-year forward, 1-year inflation swap rate has risen about 20 basis points towards 2.5%. Hornbach noted that if this rate were to decline, it would be a signal to buy US Treasury assets and price in more rate cuts, as the market's focus would shift from inflation fears to concerns about demand destruction. "This is the most important gauge on your dashboard," he said.
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