Morgan Stanley has adjusted their forecast, now anticipating two rate cuts by the Federal Reserve before the end of the year. They expect the first rate cut in September and the second in December.
After these cuts, Morgan Stanley predicts the Federal Reserve will continue to reduce rates once every quarter in 2026. They aim to reach a terminal target range of 2.75% to 3.00%.
Shift in Expectations
We’ve seen a significant shift in expectations, with a forecast now calling for two rate cuts by the end of this year, starting in September. This pivot has already caused the CME FedWatch Tool to jump from a 45% probability to over 70% for a September cut in just the last 24 hours. Given we are just a few weeks from that meeting, traders need to reposition for a more dovish Federal Reserve.
This outlook is a clear positive for equity markets, which have been trading sideways for most of August 2025, weighed down by fears of “higher-for-longer” rates. Traders may consider buying near-term call options on indices like the S&P 500 to capitalize on a potential relief rally. This renewed optimism contrasts sharply with the sentiment following the Jackson Hole symposium just weeks ago, where the tone was much more cautious.
For those trading interest rates, positioning for lower yields is now the primary focus. The 2-year Treasury yield, which is highly sensitive to Fed policy, already dipped 15 basis points to 3.95% on this news. We believe going long December 2025 SOFR futures is a direct way to express this view, as the contract will gain value as the market prices in cuts.
Impact on Market Volatility
We should also consider the impact on market volatility. While the VIX is currently subdued near 14, we expect it to climb as we approach the September 20th FOMC meeting for definitive confirmation. Buying short-dated VIX call options could be a prudent hedge against any surprise, similar to the market pullback we saw after the hawkish language in the spring of 2024.
This dovish shift will likely put downward pressure on the U.S. dollar, which has remained strong, trading above 105 on the DXY index for the past month. We see potential in positioning for a weaker dollar against currencies where the central bank is likely to remain on hold, such as the Euro. Derivative traders could look at selling DXY futures or buying at-the-money EUR/USD call options.
