Fed Decision Preview for Next Week: “Pause” is certain, but what’s uncertain is whether it will be a “hawkish or dovish pause.”

Morgan Stanley points out that the upcoming January FOMC meeting next week will undoubtedly keep rates unchanged, but the key lies in guidance. According to Chasing Wind Trading Desk, on January 23, Morgan Stanley's latest report expects the Fed to soothe the market with a "dovish pause," meaning that while rate cuts are paused due to the recent stabilization in the labor market, the tendency toward further easing is still retained. For investors, the main focus of this meeting is forward guidance. Morgan Stanley forecasts that the Fed will keep the federal funds rate target range unchanged at 3.50%-3.75% at the January meeting. This is not a return to the tightening cycle, but rather a tactical adjustment based on recent data. Subtle changes in statement wording: Morgan Stanley expects the FOMC statement to upgrade its assessment of economic growth from "moderate" to "robust." More importantly, it is expected the Fed will delete the reference to "increased downside risk to employment" — since a pause in rate cuts is chosen, logically it means their concern about the labor market has eased. Retaining an easing tendency: The key lies in forward guidance. Morgan Stanley expects the statement to retain wording such as "considering the range and timing of further adjustments to the target range." Voting outcome: Dissenting votes are expected. Morgan Stanley predicts Governor Miran will dissent, advocating for a 50 basis point rate cut. Morgan Stanley expects the Fed to implement a "dovish pause," with the statement retaining wording about "considering additional adjustments" rather than "any adjustments," suggesting the dovish bias remains. Powell Press Conference Preview: Acknowledging Growth While Not Abandoning Inflation Target Powell’s task at the press conference is to explain why the pause is necessary. Morgan Stanley believes Powell will rely on recent strong growth data, stabilization in hiring, and a falling unemployment rate (to 4.375%) to justify the pause. Qualitative analysis: The market’s core question is whether this is a "dovish pause" allowing for future rate cuts, or the end of the cycle? Morgan Stanley believes Powell will signal the former. Although activity data is stronger than expected, inflation data has not shown transmission effects from tariffs, and the Fed remains confident that inflation will decline later this year. Productivity puzzle: Powell is expected to be optimistic on productivity prospects (from both automation and AI), providing theoretical support for the "high growth, low inflation" soft-landing scenario. Market Strategy: Ample Liquidity, Long Swap Spreads Despite the Fed’s pause, short-term funding markets remain loose. Morgan Stanley notes that repo rates have quickly normalized to below the IORB (Interest on Reserve Balances), indicating system cash is more than ample. Reserve Management Purchases (RMP): The Fed maintains reserve levels by purchasing $40 billion of Treasury bills (T-bills) monthly. Morgan Stanley expects the SOMA account’s bill holdings to exceed $600 billion by the end of 2026. This mechanism effectively absorbs market supply and keeps funding markets stable. Trade recommendation: Based on loose funding conditions and expectations of a steeper front-end curve, Morgan Stanley’s rate strategy team continues to recommend being long the 2-year UST SOFR swap spread, with a target of -14bp. FX Outlook: Dollar Decline Stalls, But Still Bearish Morgan Stanley has adjusted its FX market outlook. Previously, they saw US economic weakness in early 2026 dragging the dollar down, but recent data shows strong US growth (2026 GDP growth forecast raised to 2.4%) and delayed Fed rate cuts (from January to June and September). Nonetheless, Morgan Stanley still maintains a moderately bearish view on the dollar, for the following reasons: Global growth synchronization: Data from the Eurozone, Canada, and Australia is also strong, limiting the one-way support for the dollar from rate differentials. Yen valuation: The yen remains undervalued by about 10% relative to Fed pricing. Morgan Stanley believes the BOJ is not behind the curve and concerns over Japan’s fiscal risks are exaggerated; yen’s negative premium is expected to narrow. RMB factor: USD/CNY is expected to reach 6.85 by the end of Q1 2026, also adding downward pressure to the dollar. Asset Class Focus: MBS and Municipal Bonds’ Valuation Dilemma Agency MBS (mortgage-backed securities): After GSEs (government-sponsored enterprises) announced a $200 billion purchase plan, MBS spreads have significantly narrowed, even below the average level during previous Fed reinvestment periods. Morgan Stanley strategists have thus turned neutral. While delayed Fed rate cuts usually weigh on MBS, the overwhelming net demand from the massive purchase plan offsets this negative impact. Municipal Bonds: The fundamentals are solid but valuations are expensive. The yield ratio of 1-5 year municipal bonds to corporates is at extremely low levels. Morgan Stanley warns that if the Fed opts for an "ambiguous pause" instead of a clear dovish signal, the compression of front-end muni spreads may not last, and could even prompt SMA (separately managed accounts) buyers to switch to corporates or Treasuries. Risk Disclaimer The market involves risks; invest cautiously. 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