Morgan Stanley IM: The First Cut Is (Still) the Deepest

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One year after its decisive 50-basis-point “first cut,” the Fed delivered a more restrained 25-basis-point reduction this September, lowering its target rate to 4.00%–4.25%. While speculation swirled about multiple dissenters favoring a larger cut, only one member broke from consensus—underscoring the Fed’s cautious stance.

Market expectations ahead of the September 17 meeting were the most dovish since April’s post–Liberation Day turmoil, yet the Fed’s decision reminded investors that policymakers remain committed to maintaining positive real rates until inflation expectations are fully anchored. Despite progress in disinflation, with core PCE at 2.9% and unemployment near 4.2%, the Fed signaled that inflation’s “last mile” remains the hardest.

Fed’s Measured Cut Flattens Curve, Signals Caution
The Fed’s first rate cut of 2025—25 basis points (bps) —tempered expectations for aggressive easing. Despite early-month weak jobs data, stronger activity later reduced urgency for further cuts. The U.S. yield curve flattened, with long-end Treasuries outperforming.

Global Divergence in G7 Central Bank Policy
While the Fed and Bank of Canada eased rates, the European Central Bank, Bank of England, and Bank of Japan held steady. Canada’s cut reflected domestic weakness, while Europe grappled with political gridlock and inflation persistence. Japan maintained its cautious hiking stance.

Dollar Mixed as FX Markets React to Policy Shifts
The Bloomberg Dollar Index was flat, but USD weakened against high-carry and cyclical currencies. The euro edged higher, while New Zealand Dollar and Canadian Dollar lagged amid diverging central bank paths and growth outlooks.

Emerging Market Debt Strengthens on Easing and Inflows
Emerging markets gained as the Fed and EM central banks eased policy. Argentina and Indonesia faced political risks, but strong inflows—$4.6B total—supported hard and local currency debt. 1 Credit spreads tightened across sovereign and corporate segments.

Investment Grade Credit Tightens Amid Strong Demand and M&A Surge
Global IG spreads narrowed by 5 bps, reversing August’s widening. Financials and consumer non-cyclicals led gains. M&A activity surged, highlighted by a record $55B leveraged buyout of Electronic Arts. 2 Technicals remained strong despite elevated issuance.

High Yield and Convertibles Ride Risk-On Sentiment
High yield outperformed IG, supported by firm demand and record issuance. Convertibles rallied with equities, posting $29.9B in new deals—surpassing 2024’s full-year total. 3 Dispersion fell to its lowest since January, reflecting broad sector strength.

Agency Mortgage-Backed Securities (MBS) Outperforms as Banks Rebuild Holdings
Agency MBS, as represented by the Bloomberg US Mortgage Backed Securities Index, returned +1.22%, outperforming Treasuries. Spreads tightened, and bank holdings rose amid SLR easing. Mortgage fundamentals remained solid, with low delinquency and limited refinancing activity.

Securitized Credit Resilient Despite Mixed Signals
Asset-backed securities (ABS), Commercial MBS, and Residential MBS issuance rebounded post-summer. CMBS strength came from logistics and luxury hotels; Class B office remained weak. RMBS spreads narrowed on stable home prices and strong credit fundamentals.

Taxable Munis Extend Gains, Trail Tax-Exempts
Taxable municipals returned +1.29%, underperforming tax-exempts (+2.32%). 4 Long-duration bonds led, with revenue sectors outperforming. Issuance remained light, and spreads narrowed slightly. The index yielded 4.84%, offering a 90 bp spread over Treasuries.

RISK CONSIDERATIONS

Diversification neither assures a profit nor guarantees against loss in a declining market.

There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g., natural disasters, health crises, terrorism, conflicts, and social unrest) that affect markets, countries, companies, or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g., portfolio liquidity) of events. Accordingly, you can lose money investing in a portfolio. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market, and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, and correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.