The market underestimates the probability of a "mild recession" in the United States, with a potential 100 basis points rate cut by the end of next year; Morgan Stanley is optimistic about U.S. Treasury bonds

Morgan Stanley believes that the market has underestimated the risk of a mild recession in the United States, and the Federal Reserve may cut interest rates more quickly and aggressively.

On Friday, August 29, according to Wind Trading Desk, Morgan Stanley released its latest research report stating that if the U.S. economic growth slows down in the future, or even enters a mild recession, the Federal Reserve may be forced to significantly cut interest rates to rescue the market, while the market has not fully reflected this possibility.

In the baseline scenario, Morgan Stanley expects the Federal Reserve to cut interest rates by 25 basis points at every other meeting starting in September 2025, with the rate falling to 2.625% by the end of 2026. They also proposed three alternative scenarios: a 10% probability of economic overheating due to fiscal stimulus, a 10% probability of strong consumption but the Federal Reserve tolerating inflation, and a 30% probability of a mild recession.

Morgan Stanley pointed out that the market currently underestimates the possibility of a recession, which does not match the downside risks in the U.S. labor market. Once the market assigns a higher probability to a mild recession, the federal funds rate at the end of 2026 could be nearly 100 basis points lower than the current pricing. Therefore, Morgan Stanley recommends that investors position themselves in medium to long-term U.S. Treasuries in advance and adopt a steepening yield curve strategy.

Morgan Stanley Adjusts Baseline Scenario: Rate Cuts Every Other Meeting Starting in September

Based on Powell's speech at Jackson Hole, Morgan Stanley's U.S. economists updated their Federal Reserve policy forecasts.

They now expect the first rate cut of 25 basis points at the FOMC meeting in September 2025, followed by a 25 basis point cut at every other meeting until the end of 2026. For example, cuts in September, no change in November, a cut in December, and another cut in March next year...

Although the pace of rate cuts has significantly accelerated compared to previous forecasts, the final rate target remains at 2.625% by the end of 2026.

Three Alternative Scenarios: Probability of Mild Recession as High as 30%

At the same time, Morgan Stanley predicted three possible interest rate paths for the Federal Reserve and assigned probabilities to their occurrence.

The first scenario is that the government expands fiscal stimulus, coupled with soaring consumer and business confidence, leading to a hotter economy. In this case, the Federal Reserve may not cut rates and may even consider raising them again. The probability of this scenario occurring in the future is 10%.

The second scenario is that consumer enthusiasm remains high, but the Federal Reserve "closes one eye and opens the other," increasing its tolerance for inflation. As a result, the Federal Reserve may still cut rates, but not too quickly or deeply. The probability of this scenario occurring in the future is 10%.

The third scenario involves trade shocks or issues with capital flows, where many companies suddenly find it difficult to secure financing, potentially leading to a mild recession. In this case, the Federal Reserve may be forced to cut rates significantly to rescue the market, even cutting by 50 basis points at once. The probability of this scenario occurring in the future is 30%.

Morgan Stanley pointed out that the current market-implied interest rate path assigns only about a 20% weight to dovish scenarios (such as economic slowdown), which does not match the downside risks in the U.S. labor market. Once investors begin to assign a higher probability to these "dovish scenarios," especially the mild recession in the U.S. or the Federal Reserve becoming more "tolerant of inflation," **the market pricing for the federal funds rate at the end of 2026 could be adjusted down nearly 100 basis points from the current level **

Morgan Stanley believes that in this context, it is even more necessary to position in long-term bonds or implement a steepening yield curve strategy, including going long on 5-year U.S. Treasuries or buying January 2026 federal funds futures.

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