Morgan Stanley believes the market is underestimating the risk of a mild US recession, suggesting the Federal Reserve may cut rates more aggressively and rapidly than currently anticipated.

On Friday, August 29, Morgan Stanley released a research report stating that if US economic growth deteriorates or enters a mild recession, the Federal Reserve may be forced to implement substantial rate cuts to support the market, a possibility not fully reflected in current market pricing.

Under their baseline scenario, Morgan Stanley expects the Fed to cut rates by 25 basis points every other meeting starting September 2025, with rates reaching 2.625% by the end of 2026. The firm also presents three alternative scenarios: a 10% probability of economic overheating due to fiscal stimulus, a 10% probability of strong consumption with Fed inflation tolerance, and a 30% probability of mild recession.

Morgan Stanley notes that markets currently underestimate recession risks, which doesn't align with downside risks in the US labor market. Should markets assign higher probability to a mild recession, the federal funds rate by end-2026 could be nearly 100 basis points lower than current pricing. Therefore, Morgan Stanley recommends investors position ahead in medium and long-term Treasuries while adopting yield curve steepening strategies.

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

Following Powell's Jackson Hole remarks, Morgan Stanley's US economists updated their Federal Reserve policy forecasts.

They now anticipate the first 25 basis point rate cut at the September 2025 FOMC meeting, followed by 25bp cuts every other meeting through end-2026 - for example, cutting in September, holding in November, cutting in December, then cutting again in March of the following year.

While the pace of rate cuts has accelerated significantly compared to previous forecasts, the terminal rate remains at 2.625% by end-2026.

**Three Alternative Scenarios: 30% Probability of Mild Recession**

Simultaneously, Morgan Stanley forecasts three possible Federal Reserve rate paths with assigned probabilities.

The first scenario involves expanded government fiscal stimulus combined with surging consumer and business confidence, leading to economic overheating where the Fed may not cut rates or even consider raising them again. This scenario carries a 10% probability.

The second scenario features strong consumer spending enthusiasm while the Fed adopts a more tolerant stance toward inflation. The result would be Fed rate cuts, but not as rapid or deep. This scenario also carries a 10% probability.

The third scenario involves trade shocks or capital flow disruptions, leaving many companies unable to secure financing and potentially entering mild recession, forcing the Fed to implement substantial rate cuts, possibly even 50bp at once. This scenario carries a 30% probability.

Morgan Stanley points out that current market-implied rate paths assign only about 20% weight to dovish scenarios (such as economic slowdown), which doesn't match downside risks in the US labor market. Once investors begin assigning higher probabilities to these "dovish scenarios," particularly US mild recession or increased Fed inflation tolerance, market pricing for the federal funds rate by end-2026 could decline nearly 100 basis points from current levels.

Morgan Stanley believes this backdrop supports positioning in long-end bonds or implementing yield curve steepening strategies, including going long 5-year Treasuries or purchasing January 2026 federal funds rate futures.