Preview of the Fed's decision next week: "Pause" is certain, what is uncertain is "whether it will be a hawkish or dovish pause"

Morgan Stanley pointed out that the January FOMC meeting next week is expected to maintain interest rates unchanged, but the key lies in the tone. According to Windcatcher Trading Platform, on January 23, Morgan Stanley's latest report predicts that the Fed will soothe the market through a "dovish pause," meaning that although interest rates will be paused due to recent stability in the labor market, the tendency towards further easing will still be retained. For investors, the key to this meeting lies in the forward guidance. According to Morgan Stanley's forecast, the Fed will keep the federal funds rate target range unchanged at 3.50%-3.75% at the January meeting. This is not a return to a tightening cycle, but a tactical adjustment based on recent data. Subtle changes in the statement wording: Morgan Stanley expects the FOMC statement to raise its assessment of economic growth from "moderate" to "robust." More importantly, it is expected that the Fed will remove the mention of "increased downside risks to employment" - since choosing to pause rate cuts logically implies that their concerns about the labor market have eased. Retaining a dovish stance: The key lies in the forward guidance. Morgan Stanley predicts that the statement will retain language such as "when considering further adjustments to the target range and timing." Voting scenario: Dissenting votes are expected. Morgan Stanley predicts that board member Miran will cast a dissenting vote, advocating for a 50 basis point rate cut. Morgan Stanley expects the Fed to implement a "dovish pause," with the key being that the statement retains language indicating further considerations for adjustments rather than any specific adjustments, implying that the dovish stance is still in place. Powell's press conference preview: Acknowledging growth, but not giving up on the inflation target Powell's task at the press conference is to explain the reasoning behind the pause. Morgan Stanley believes that Powell will defend the "pause" by relying on recent strong growth data, stabilization in hiring, and a decrease in the unemployment rate (to 4.375%). Qualitative analysis: The core question in the market is whether this is a "dovish pause" for future rate cuts or the end of a cycle. Morgan Stanley believes that Powell will convey the former. Although activity data is stronger than expected, inflation data has not shown the transmission effects of tariffs, and the Fed remains confident that inflation will fall later this year. The mystery of productivity: Powell is expected to be optimistic about the prospects for productivity (whether from automation or AI), which provides theoretical support for the script of a "high growth, low inflation" soft landing. Market strategy: abundant liquidity, long on swap spreads Despite the Fed pausing rate cuts, the short-term financing market environment remains accommodative. Morgan Stanley points out that repo rates have quickly normalized below the Interest on Reserves Balances (IORB), indicating an "oversupply" of cash in the system. Reserve Management Purchases (RMP): The Fed maintains reserves through monthly purchases of $400 billion in Treasury bills (T-bills). Morgan Stanley expects the amount of notes held in the SOMA account to exceed $600 billion by the end of 2026. This mechanism effectively absorbs market supply and maintains stability in the financing market. Trading recommendation: Based on accommodative financing conditions and expectations of steepening yield curves, Morgan Stanley's rate strategy team maintains a recommendation to go long on 2-year UST SOFR swap spreads, with a target position set at -14bp. Forex outlook: Dollar decline halted, but still bearish Morgan Stanley's view on the forex market has been revised. Previously, they believed that the U.S. economy would weaken in early 2026, dragging down the dollar, but current economic data shows strong growth in the U.S. (with GDP growth expectations for 2026 raised to 2.4%) and a delay in Fed rate cuts (from January to June and September). Nevertheless, Morgan Stanley still maintains a moderately bearish view on the dollar for the following reasons: Global growth sync: Data from the Eurozone, Canada, and Australia is also strong, limiting the unilateral support of interest differentials for the dollar. Yen valuation: The yen is still underestimated by about 10% relative to Fed pricing. Morgan Stanley believes that the Bank of Japan is not lagging behind the curve and concerns about fiscal risks in Japan are exaggerated, expecting the yen's premium to converge. Yuan factor: USD/CNY is expected to reach 6.85 by the end of the first quarter of 2026, which also puts downward pressure on the dollar. Asset class focus: Valuation challenges for MBS and municipal bonds Institutional MBS (Mortgage-Backed Securities): After the GSE announced a $200 billion purchase plan, MBS spreads have narrowed significantly, even surpassing the average levels seen during the Fed's reinvestment period. As a result, Morgan Stanley's strategists have turned neutral. Although a Fed pause typically is not favorable for MBS, the massive purchase plan's net demand is enough to offset this negative impact. Municipal bonds: Fundamentals are sound, but valuations are expensive. Yield ratios of 1-5 year municipal bonds to corporates are at extremely low levels. Morgan Stanley warns that if the Fed only offers a "vague pause" rather than a clear dovish signal, the compression of municipal bond spreads at the front end will be difficult to sustain, and may even lead SMA buyers to switch to corporates or treasuries.