As oil prices soar, reshaping the path of interest rate cuts, Morgan Stanley goes against the trend and holds firm to the script of a June rate cut by the Federal Reserve.

Despite the soaring oil prices under the new round of geopolitical storms in the Middle East, which is prompting senior traders in the global financial markets to significantly reduce their bets on the extent to which the Federal Reserve and other global central bank policymakers will lower benchmark borrowing costs this year, Wall Street financial giant Morgan Stanley still insists on its monetary policy forecast path - that the Fed will resume rate cuts in June and announce another rate cut in September. In comparison, the stance of interest rate futures traders appears cautious under the pessimistic expectations of "stagflation" caused by the soaring oil prices. The "CME FedWatch Tool" shows that they generally predict only one rate cut this year, significantly pushed back to September instead of the previously expected first half of the year. "We still adhere to the judgment that the Fed will cut rates in June and September, of course, the risk is that it may indeed be further delayed," Michael Gapen, Chief U.S. Market Economist at Morgan Stanley, said at a roundtable discussion in New York on Monday. This prediction is contrary to the pricing in the interest rate futures market, and is also more dovish compared to the expected path of Wall Street peers. Wall Street giants such as Goldman Sachs have already pushed back the Fed's first rate cut of 2026 to September. After the Iran war, oil prices soared rapidly, threatening to reignite inflation. This could hinder the Fed's ability to further loosen monetary policy, so the market quickly reduced pricing for rate cuts and began pricing in the possibility of the U.S. and global economies falling into "stagflation" due to the sharp rise in oil and gas prices - for the Fed and other major central banks globally, "stagflation" is perhaps the most difficult long-term economic challenge to resolve among all macroeconomic issues. Interest rate futures tied to the Fed's policy rate currently show that only a 25 basis point rate cut will be announced at the Fed meetings before December of this year, with a 60% probability of a 25 basis point rate cut in September. The latest pricing is significantly lower than the expectation of at least 50 basis points in the market just last month. Economists from Deutsche Bank and Barclays postponed their forecasts for the next Fed rate cut from June to September last week. As shown above, the market's pricing for a rate cut by the Fed before the end of the year - pricing in the swap market shows that the Fed will cut interest rates by 25 basis points before December, significantly cooling compared to the pricing last month. "Stagflation" concerns continue to disrupt market pricing Two key inflation readings in the U.S. over the past week have sent the same message: inflation remains stubbornly above the Fed's 2% inflation target, and combined with the recent sharp rise in international oil prices due to a new round of geopolitical storms in the Middle East, global investors are increasingly worried that so-called "stagflation" will appear, which is why the 10-year U.S. Treasury yield, known as the "anchor of global asset pricing," and the shorter-term 2-year U.S. Treasury yield have recently surged. While expectations for rate cuts have significantly cooled, the U.S. bond market experienced a round of massive sell-offs last week, pushing the most interest rate-sensitive two-year U.S. Treasury yield to nearly 3.75%, higher than the Fed's interest on reserves rate - a level rarely breached. A market pricing gauge known as the "terminal rate" - reflecting where the Fed will finish the current easing cycle - has risen by about 50 basis points since the end of February, reaching above 3.4%. "I am somewhat surprised by the significant increase in the two-year U.S. Treasury yield. Of course, I understand that perhaps long-term rates will also rise, but I am still very surprised that the terminal rate has been repriced to such a high level," said Gapen from Morgan Stanley in an interview. Gapen also pointed out the downside risks: if the Fed delays the first rate cut until September or even December, the window for the next rate cut may be postponed to 2027. While Morgan Stanley maintains its core forecast, Gapen also clearly points out the downside risks: if the Fed postpones the first rate cut to September or December, the window for the next rate cut may be extended to 2027. "The risk our view faces is that the longer the Fed waits, and the longer the wait, the more likely that the central bank may need to implement even more rate cuts." Market observers are generally worried that the U.S. will enter a period of stagflation. Oil prices have risen by 50% in the past month, inflation remains high, but the U.S. lost 92,000 jobs in February, and data released on Friday also showed that GDP growth in the fourth quarter was weaker than expected. Therefore, against the backdrop of stagflation, the speeches of the Fed and other major central banks this week on monetary policy and future economic trends are crucial. The Fed, as well as the ECB, BOE, and BOJ, will announce interest rate decisions, with the market closely watching the convergence of the Fed's rate-cut grid and the suspense of the BOJ's rate hike, while the central banks of Australia, Indonesia, and Brazil will also speak one after another. The forex and bond markets face a major test. Under the impact of oil prices, the probability of economic recession increases Brent crude oil closed above $100 per barrel for the third consecutive trading day, the longest since August 2022. Investors are weighing signs of short-term supply abundance on the one hand and evaluating the increasing military strike threats facing energy infrastructure in the Middle East. On Monday, in volatile oil price trading, Brent crude oil, the global benchmark, fell 2.8% to $100 per barrel, while West Texas Intermediate crude oil futures closed at $93.50 per barrel. According to Morgan Stanley's latest research report, if energy prices remain between $125 and $150 per barrel for a long period of time, it will significantly drag down consumer spending and require support from the Fed. According to Gapen, the probability of a U.S. economic recession has risen to about 20%, higher than the 10% before the start of the military conflict. "The economy can withstand oil prices between $90 and $100 per barrel. But you may indeed see oil prices staying in the range of about $125 to $150 for some time, which would roughly correspond to a reasonable probability of a recession," he said. A key indicator worth noting for investors Seth Carpenter, Global Chief Economist at Morgan Stanley, said at another meeting that the inflation surge driven by oil prices is likely to be temporary. "If the situation deteriorates to the point of impacting economic growth, then over time, this will actually further suppress potential inflation trends, especially core inflation," he said. Matthew Hornbach, Global Head of Macro Strategy at Morgan Stanley, also said that the "inflation swap," a key indicator, may be a way to measure to what extent high oil prices are suppressing market demand. Since crude oil prices first jumped above $100 per barrel in 2022, the one-year forward one-year inflation swap rate has risen by about 20 basis points to 2.5%. Hornbach said that if this rate falls, it would be a signal to buy U.S. Treasury assets and factor in more rate cuts, as the market would shift from worrying about inflation to worrying about demand destruction. "This is the most important indicator on your dashboard," he said.