Big aggressive rate cuts coming within months, say UBS, Morgan Stanley

Strategists at UBS Investment Bank have made bold predictions regarding the Federal Reserve's future interest rate cuts, based on their expectations of an economic downturn.

UBS Investment Bank's Arend Kapteyn and Bhanu Baweja have forecasted that the Federal Reserve will start on a substantial monetary policy easing cycle, cutting interest rates by a remarkable 275 basis points in the coming year. This projection is nearly four times more aggressive than what the markets are currently pricing. The strategists argue that a persistent decline in inflation will create favorable conditions for the central bank to initiate policy adjustments as early as March, with rate reductions expected to be substantial, mirroring a typical easing cycle.

Baweja highlighted the rationale behind their prediction, telling Bloomberg, "We don't see the conditions for why this time is so different. Inflation is normalizing quickly, and by the time we get to March, the Fed will be looking at real rates which are very high."

The strategists further anticipate that the benchmark federal funds rate will drop to a range between 2.5% and 2.75% by the end of 2024, with a terminal rate of 1.25% projected by early 2025. Their outlook is anchored in the belief that the US economy will slip into recession by the second quarter of the upcoming year.

In contrast to UBS's bold prediction, money markets are currently pricing in a more conservative scenario, expecting the Federal Reserve to cut rates by only 75 basis points, with the process commencing in July.

To substantiate their forecasts, Kapteyn and Baweja point to historical easing cycles over the last three decades, where central banks in Group of 10 countries (excluding Japan) typically lowered interest rates by an average of 320 basis points over a span of 15 months. They argue that this time will be no different, with nearly all major central banks expected to engage in more aggressive rate cuts than what the markets are currently factoring in.

Wall Street banks remain divided in their outlook for policy easing, with Morgan Stanley anticipating substantial rate reductions reaching 2.375% in 2025 while Goldman Sachs Group Inc. maintains a more conservative stance, forecasting fewer cuts and a later initiation of the easing cycle reaching 3.5% to 3.75% by 2026.

In addition to their predictions for the U.S., UBS Investment Bank is also outspoken on the euro zone, where they anticipate the region to narrowly avoid a recession. This outlook would enable the European Central Bank to delay its own policy easing measures. Baweja and Kapteyn expect the ECB to commence its cutting cycle following the Federal Reserve, starting in June, and to implement rate cuts totaling 75 basis points. This view contrasts with money markets, which are pricing in 100 basis points of easing, beginning as early as April.

While the anticipated trajectory of lower interest rates by the Federal Reserve is likely to weaken the US dollar and exert downward pressure on Treasury yields, Baweja anticipates that the 10-year Treasury yield will bottom out at 3.5% in the next year, as the issuance of US debt remains elevated. He explains, "In a cycle that is very aggressive in coming down 275 basis points, we see the 10-year only coming down around 100 basis points."