Morgan Stanley points out that the upcoming January FOMC meeting will undoubtedly keep interest rates unchanged, but the key lies in the tone it will set. According to the trading desk, on January 23rd, Morgan Stanley's latest report predicts the Federal Reserve will soothe the markets with a "dovish pause," meaning that while pausing rate cuts due to recent labor market stabilization, it will retain a bias towards future easing. For investors, the key to this meeting lies in the forward guidance. According to Morgan Stanley's forecast, the Fed will maintain the federal funds rate target range at 3.50%-3.75% at the January meeting. This is not a return to a tightening cycle but rather a tactical adjustment based on recent data.
Subtle changes in the statement's wording: Morgan Stanley expects the FOMC statement to upgrade its assessment of economic growth from "moderate" to "solid." More importantly, it anticipates the Fed will remove the phrase about "increased downside risks to employment"—since they chose to pause cuts, it logically implies their concerns about the labor market have eased.
Retaining an easing bias: The key lies in the forward guidance. Morgan Stanley expects the statement to retain the phrase "in determining the extent and timing of any further adjustments to the target range."
Voting situation: Dissenting votes are expected. Morgan Stanley predicts Governor Miran will dissent, advocating for a 50-basis-point rate cut.
Morgan Stanley expects the Fed to execute a "dovish pause," with the key being the statement's retention of the phrasing "considering additional adjustments" rather than "any adjustments," to signal that the easing bias remains. Powell Press Conference Preview: Acknowledging Growth, But Not Abandoning Inflation Target Powell's task at the press conference will be to explain the pause. Morgan Stanley believes Powell will rely on recent strong growth data, stabilized hiring, and a decline in the unemployment rate (to 4.375%) to justify the "pause."
Qualitative analysis: The core question for the market is: Is this a "dovish pause" intended to be followed by more cuts later, or is it the end of the cycle? Morgan Stanley believes Powell will signal the former. Although activity data has been stronger than expected, inflation data has not shown pass-through effects from tariffs, and the Fed remains confident inflation will decline later this year.
The productivity puzzle: Powell is expected to express optimism about productivity prospects (whether from automation or AI), which provides theoretical support for the "high growth, low inflation" soft-landing narrative.
Market Strategy: Ample Liquidity, Long Swap Spreads Despite the Fed's pause on rate cuts, conditions in short-term funding markets remain accommodative. Morgan Stanley notes that repo rates have normalized quickly to below the IORB rate, indicating "more than ample" cash in the system.
Reserve Management Purchases (RMP): The Fed is maintaining reserve levels by purchasing $40 billion in Treasury bills monthly. Morgan Stanley expects the volume of bills held in the SOMA account to exceed $600 billion by the end of 2026. This mechanism effectively absorbs market supply and keeps funding markets smooth.
Trading recommendation: Based on accommodative funding conditions and expectations for a steeper front-end of the yield curve, Morgan Stanley's rates strategy team maintains its recommendation to go long 2-year UST SOFR swap spreads, targeting -14 basis points.
FX Outlook: Dollar Decline Halted, But Still Bearish Morgan Stanley's view on the foreign exchange market has undergone a revision. Previously, they expected US economic weakness in early 2026 to drag the dollar down, but current data shows strong US growth (2026 GDP growth forecast raised to 2.4%), and the Fed's rate cut timeline has been delayed (from January to June and September). Nevertheless, Morgan Stanley maintains a moderately bearish view on the dollar for the following reasons:
Synchronized global growth: Data from the Eurozone, Canada, and Australia is also strong, limiting unilateral support for the dollar from interest rate differentials.
Yen valuation: The yen remains undervalued by about 10% relative to Fed pricing. Morgan Stanley believes the Bank of Japan is not behind the curve, concerns about Japanese fiscal risks are exaggerated, and expects the yen's negative premium to converge.
Renminbi factor: USD/CNY is expected to reach 6.85 by the end of Q1 2026, which also constitutes downward pressure on the dollar.
Asset Class Focus: Valuation Dilemma for MBS and Munis
Agency MBS: Following the announcement of a $200 billion purchase plan by the GSEs, MBS spreads have narrowed significantly, even breaking through the average levels seen during past Fed reinvestment periods. Morgan Stanley strategists have therefore turned neutral. Although a Fed delay in cutting rates is typically negative for MBS, the sheer net demand from the massive purchase plan is enough to offset this negative impact.
Municipal bonds: Fundamentals are solid, but valuations are expensive. The yield ratio of 1-5 year municipal bonds to corporate bonds is at extremely low levels. Morgan Stanley warns that if the Fed delivers only an "ambiguous pause" rather than a clear dovish signal, the spread compression in front-end munis will be difficult to sustain and could even lead SMA buyers to shift to corporates or Treasuries.
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