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Wall Street sees even more Fed rate cuts ahead with Morgan Stanley predicting a return to zero

Key Points
  • Wall Street economists see the Federal Reserve continuing to cut interest rates after July's first move lower in 11 years.
  • UBS sees at least three more cuts ahead, while Morgan Stanley is indicating a possible return to the near-zero rates that prevailed from 2008-15.
  • Recession fears are rising, specifically because of increasing trade tensions between the U.S. and China.

As trade tensions escalate and economic indicators weaken, Wall Street is beginning to anticipate more aggressive interest rate cuts from the Federal Reserve, with at least one forecast seeing a return to near zero.

Economists now see the likelihood of three quarter-point reductions before the end of the year, along with multiple moves in 2020 until it becomes clear that the U.S. central bank has staved off a recession. The anticipation comes as Goldman Sachs just announced that it reduced its GDP projections by 0.2 percentage point and Bank of America Merrill Lynch said it sees increasing chances of a recession in the next 12 months.

Other forecasters on the Street are joining the calls for weakening conditions that prompt the Fed to take a sharper knife to rates than officials indicated at the July meeting, which saw the first rate reduction in 11 years.

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"Slower growth and rising risks will likely impel the Fed to cut rates further," UBS economist Seth Carpenter said in a report for clients. "Although we saw little support from the [Federal Open Market] Committee for further cuts at the July meeting, trade developments should provide enough justification to cut in" September.

Carpenter sees another cut in December then one final reduction in March 2020 for a full cycle of 100 basis points lower, taking the Fed's benchmark funds rate down to a range of 1% to 1.25%. That jibes with current pricing in the futures market which sees the funds rate around 1.12% by the end of next year.

The projection, though, is still a far cry from where committee members anticipate rates heading.

In their most recent projections in June, they indicated the longer-run funds rate to be at 2.5%, or higher than the current target range of 2% to 2.25%. However, that forecast came before July's rate cut and, perhaps more importantly, a day before President Donald Trump's announcement that he intends to levy tariffs on the remaining $300 billion or so of Chinese imports not already targeted.

"Trump's announcement ... that tariffs on the final tranche of Chinese imports would be implemented September 1 has changed the outlook," Carpenter said. "The new tariffs will slow growth. We anticipate the Fed eases policy further because of the slowdown and their fears of increased uncertainty."

Morgan Stanley: Back to zero

The cut in September, he said, likely would be framed as another insurance policy against future uncertainty. By December, though, the easing would be in response to data showing material weakness in the economy.

Morgan Stanley anticipates successive cuts at the September and October FOMC meetings and an even steeper path ahead, with four more rate moves in 2020 taking the funds rate close to zero, or where it was during the financial crisis and stayed for seven years. Strategist Mark Cabana of BofAML also recently told CNBC that zero rates could come if trade tensions keeping rising.

"Taking a walk through Chair Powell's checklist of factors the FOMC will be looking at when deliberating policy adjustments going forward, it seems to us there is already a clear need to cut rates further," Ellen Zentner, a Morgan Stanley economist, said in a note, citing a reduction in hours worked for July, typically a precursor to layoffs.

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Zentner anticipates the cuts to be of the standard 25 basis point variety, but said a bigger move "cannot be ruled out, especially if policymakers see convincing enough evidence in the data that their baseline outlook for the economy has been disrupted, and a pronounced downturn has become more likely."

That comes amid heightened fears about the economy slipping into outright recession spurred in large part by the U.S.-China trade war.

Companies increasingly are citing tariffs as a headwind, with 28% of corporate officials mentioning the issue during second-quarter earnings calls, according to FactSet. That's a 41% increase from the previous quarter.

Bank of America Merrill Lynch, in a recent report, put the chance of a recession in the next 12 months at 1 in 3. That's about in line with the New York Fed's own recession indicator that uses the difference between 10-year and 3-month government bond yields to gauge the chance of a downturn. That indicator puts the chances at 31.5%. The two notes' yields have been inverted for months.

Morgan Stanley's forecast of a near-zero funds rate comes amid some speculation that the Fed might take nominal rates to below zero if things deteriorated even more drastically. In Germany, for instance, yields already are negative across the entire yield curve.

However, none of the current forecasts are for negative yields. The closest the Fed has ever come to entertaining the idea was three years ago when it instructed banks to prepare for a negative-yield scenario in their mandated stress tests.

A "more aggressive Fed would have had a better chance of convincing investors that it had things under control and that, due to its actions, would need to ease less in the future. In addition, a more aggressive Fed would have a better chance of boosting inflation expectations," Zentner wrote. "However, based on our economists' forecasts for Fed policy, we don't have an aggressive Fed today. Instead, we have a Fed that is easing policy almost as gradually as it tightened it."