US markets are heading into this week’s Federal Reserve decision largely prepared for a quarter-point interest-rate increase.
Morgan Stanley thinks investors may be paying too much attention to Wednesday and not enough to what comes next.
The bank now expects the Fed to raise rates by 25 basis points in both September and December, a more hawkish path that would turn this week’s move from a one-off response to sticky inflation into the start of renewed tightening.
That possibility is gaining weight as oil trades above $100 a barrel and Treasury yields climb.
The 10-year yield moved above 5.02% on Tuesday, its highest since 2007, while markets put the probability of a quarter-point Fed increase this week at about 93%.
Morgan Stanley sees inflation risk lasting beyond September
Morgan Stanley’s economists said the US disinflation process has become slower and less convincing than policymakers are likely to accept.
Their concern extends beyond one inflation print.
The bank pointed to possible second-round effects from expensive energy, strong demand generated by AI-related investment, a potentially higher neutral interest rate and the need for the Fed to preserve its inflation-fighting credibility.
Taken together, those forces tilt the policy outlook towards greater restraint, according to the bank.
Morgan Stanley therefore expects another 25-basis-point increase in December and sees officials signalling that further tightening remains possible before eventually pausing.
That is a markedly different story from a Fed merely delivering an insurance hike this week and waiting for inflation to cool.
The bond market is already looking beyond one hike
Treasuries are beginning to tell a similar story.
Padhraic Garvey, ING’s head of Americas research, told Barron’s that the gap between the two-year Treasury yield and the current Fed funds rate has approached 90 basis points.
He said that is comfortably beyond the roughly 75-basis-point threshold that has historically preceded a rate increase.
Barron’s said the signal suggests bond investors may effectively be allowing for 50 to 75 basis points of tightening over the coming quarters.
Longer maturities are also flashing concern, with the 10-year Treasury yield moving through 5% as investors react to oil-driven inflation risks, resilient growth and heavy borrowing needs.
For equities, that matters even if Wednesday’s hike is already priced.
A longer tightening cycle would keep discount rates elevated and make valuations harder to defend, particularly among expensive growth stocks.
September could open the door to October and December
BMO Capital Markets is also pushing the debate beyond Wednesday.
Ian Lyngen, BMO’s head of US rates strategy, told MarketWatch that incoming economic data would help determine whether the Fed needs to raise rates again in October, December or both.
In his view, once policymakers restart tightening in September, subsequent quarter-point moves become considerably easier to justify.
That leaves investors facing a different question from the one dominating markets only days ago. The issue is no longer simply whether Chair Kevin Warsh delivers his first rate increase.
It is whether persistent inflation, oil above $100 and still-resilient demand turn September into the first step of a tightening sequence that markets have only begun to price.
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