Oil Price Surge Reshapes Rate Cut Path as Morgan Stanley Bucks Trend to Stick with Fed June Rate Cut Script

CNBC Finance APP has learned that despite the surge in oil prices driven by a new wave of Middle Eastern geopolitical turmoil, which is prompting seasoned traders in global financial markets to significantly reduce their bets on the Federal Reserve and other central banks lowering benchmark borrowing costs this year, Wall Street financial giant Morgan Stanley still maintains its forecast path for monetary policy—that the Fed will resume rate cuts in June and announce further cuts in September. In contrast, interest rate futures traders are more cautious amid concerns of stagflation caused by rising oil prices. The CME FedWatch Tool shows they generally expect only one rate cut this year, pushed back significantly to September from earlier expectations of a first-half cut.

“We still expect the Fed to cut rates in June and September, but the risk is that it could be delayed further,” Morgan Stanley’s Chief U.S. Economist Michael Gapen said Monday at a roundtable in New York.

This forecast is at odds with the pricing in the interest rate futures market, which appears more dovish compared to Wall Street peers’ expected path—major banks like Goldman Sachs have already delayed their first rate cut to September 2026. After oil prices surged rapidly following the Iran conflict, threatening to reignite inflation, markets have sharply reduced expectations for rate cuts and are beginning to price in the possibility of stagflation in the U.S. and global economies due to soaring oil and gas prices—stagflation being one of the most difficult long-term macroeconomic challenges for central banks like the Fed.

Interest rate futures tied to the Fed’s policy rate currently price in only a 25 basis point cut before December, with a 60% probability of a 25 basis point cut in September. This latest pricing is significantly lower than last month’s market expectations of at least a 50 basis point cut. Economists at TD Securities and Barclays last week also pushed back their forecasts for the next Fed rate cut from June to September.

As shown in the chart above, the market’s pricing for a rate cut by the Fed before the end of the year—swap market pricing indicates a 25 basis point cut at the December meeting—has cooled considerably compared to last month.

Concerns about stagflation continue to disrupt market pricing

Over the past week, two key U.S. inflation indicators have sent a consistent message: inflation remains stubbornly above the Fed’s 2% target, and with recent international oil prices soaring due to renewed Middle Eastern geopolitical tensions, global investors are increasingly worried about the onset of stagflation. This is reflected in the sharp rise in the 10-year U.S. Treasury yield, dubbed the “anchor of global asset pricing,” as well as the shorter-term 2-year Treasury yield.

Amid the significant cooling of rate cut expectations, the U.S. Treasury market experienced a sharp sell-off last week, with the two-year yield approaching 3.75%, surpassing the Fed’s reserve rate—an uncommon level. The so-called “terminal rate,” a market-based proxy indicating where the Fed might end its easing cycle, has risen about 50 basis points since late February, now exceeding 3.4%.

“I was a bit surprised that the two-year yield rose so much. I understand why, and maybe long-term rates will go up too, but I’m still surprised that the terminal rate has been repriced so high,” Gapen from Morgan Stanley said in an interview.

Gapen also acknowledged the possibility that the Fed might delay its first rate cut until September or even December, which could push the next rate cut into 2027.

Although Morgan Stanley maintains its baseline forecast, Gapen clearly pointed out the downside risks: if the Fed delays its first cut until September or December, the next easing cycle could be pushed back to 2027. “The main risk to our view is that the longer the Fed waits—and the longer the wait during this period—the more likely it is that the central bank will need to implement additional rate cuts later,” he said.

Market observers are generally concerned that the U.S. may enter a period of stagflation. Over the past month, oil prices have risen 50%, inflation remains high, and U.S. February employment data showed a decline of 92,000 jobs, while Friday’s GDP data indicated a sharper slowdown than expected.

In this stagflation environment, statements from the Fed and other major central banks this week regarding monetary policy and future economic outlooks will be crucial. The Fed, ECB, Bank of England, and Bank of Japan will all release rate decisions, with markets closely watching the Fed’s dot plot convergence and the potential for a Japanese rate hike. Meanwhile, the Reserve Bank of Australia, Bank Indonesia, and Banco Central do Brasil will also speak, testing the foreign exchange and bond markets.

Oil shocks increase recession risks

Brent crude oil closed above $100 per barrel for the third consecutive day, the longest streak since August 2022. Investors are weighing signs of short-term supply abundance against rising threats of military strikes on Middle Eastern energy infrastructure. On Monday, amid volatile trading, Brent fell 2.8% to $100, while WTI crude settled at $93.50 per barrel.

Morgan Stanley’s latest report states that if energy prices remain between $125 and $150 per barrel for an extended period, it will significantly dampen consumer spending and require Fed support. Gapen estimates the probability of a U.S. recession has risen to about 20%, up from 10% before the recent geopolitical conflicts.

“Economies can handle oil prices of $90 to $100 per barrel. But it’s possible that prices stay in the $125 to $150 range for a while, which would correspond to a roughly increased recession probability,” he said.

A key indicator investors should watch

Seth Carpenter, Morgan Stanley’s Chief Global Economist, said at another conference that the inflation surge driven by oil prices is likely temporary. “If the situation worsens enough to impact economic growth, over time it could actually lower the underlying inflation trend, especially core inflation,” he said.

Matthew Hornbach, Morgan Stanley’s Global Macro Strategist, added that the “inflation swap” indicator could be a way to gauge how much high oil prices are suppressing demand.

Since oil prices first surged above $100 per barrel in 2022, the 1-year forward inflation swap rate has risen about 20 basis points to 2.5%. Hornbach noted that if this rate declines, it would signal buying U.S. Treasuries and expecting more rate cuts, as markets shift from inflation concerns to demand destruction fears. “This is the most important indicator on your dashboard,” he said.