Fed's "risk-management cuts" still in play despite upward U.S. GDP revision

U.S. Q2 GDP was revised upward to 3.8%, accompanied by a decline in unemployment claims, which initially contributed to a more hawkish sentiment and a rise in the 2-year Treasury yield. Despite this stronger economic data, Morgan Stanley analysts maintain their expectation for Federal Reserve rate cuts in October and December, citing slowing real aggregate labor income and the Fed's 'risk-management' approach, though the probability of a larger half-point cut has decreased. Market pricing via CME FedWatch indicates an 88% chance of a 25-basis point cut in October.

Analysis

A dichotomy is emerging between robust U.S. economic data and persistent expectations for Federal Reserve monetary easing. The third and final estimate for Q2 U.S. GDP was revised upward to 3.8% growth, a significant increase from the previous 3.3% estimate, driven by stronger household spending. This, combined with a concurrent decline in weekly unemployment claims, prompted a hawkish reaction in the bond market, evidenced by a rise in the rate-sensitive 2-year U.S. Treasury yield. Despite this data, analysts at Morgan Stanley maintain their forecast for 25-basis point rate cuts in both October and December, framing them as 'risk-management' measures to preempt an anticipated slowdown. Their rationale is based on a rapid deceleration in real aggregate labor income growth. Market pricing, via the CME FedWatch Tool, largely aligns with this dovish outlook, indicating an 88% probability of a cut in October and a 62% chance of a subsequent cut in December. However, the strong economic figures have tempered expectations for more aggressive easing, reducing the likelihood of a half-point drawdown before year-end.

Key Decisions for Investors

• Given the high market probability (88%) of a near-term rate cut, investors may consider maintaining positions that benefit from a dovish Fed, but should be aware that unexpectedly strong inflation or employment data could rapidly alter this outlook.
• Fixed-income investors should monitor the front end of the yield curve, as the 2-year Treasury's sensitivity to strong economic data signals potential for volatility if incoming reports continue to challenge the market's aggressive rate cut pricing.
• The primary risk identified by Morgan Stanley is not fewer cuts in the near term but a potential reduction in the number of cuts in 2026, suggesting long-term investors should assess portfolio duration and rate sensitivity beyond the immediate policy cycle.