Fed’s “Normal Judgment” Could Trigger Market Correction: Insights from Morgan Stanley

The U.S. Federal Reserve’s approach to monetary policy, referred to as “normal judgment,” could pose significant risks to equity markets. According to a recent report from MarketWatch, Morgan Stanley warns that a misalignment between market expectations and the Fed’s actual policy trajectory could lead to a sharp market correction. This growing divergence highlights the precarious balance investors are navigating.

The Gap Between Market Expectations and Fed Policy

Morgan Stanley’s Chief Investment Officer and Strategist, Mike Wilson, draws attention to the discrepancy between the market’s forecast for interest rate cuts and what the Fed is likely to deliver. Investors have priced in a 0.5 percentage point rate cut by the Fed over the next year, but Wilson argues this might be unrealistic given current economic conditions.

“The U.S. economy is transitioning out of a cyclical recession and is now entering what appears to be a recovery phase,” Wilson explained. This recovery—a sign of economic resilience—reduces the urgency for aggressive rate cuts, which could clash with investor optimism for a swift easing of monetary policy.

Wilson further supported this outlook by noting improved demand in critical sectors such as housing, industrials, consumer goods, transportation, and commodities. These gains indicate an economic rebound that might reduce the need for the Fed to pursue rapid or significant rate relief.

Low-Rate Assumptions Already Embedded in Stock Prices

The expectation of lower rates is deeply embedded in equity market valuations, and this could present a major risk to market sentiment. “If the Fed does not cut rates as significantly or as quickly as anticipated, investors may face disappointment,” Wilson warned. A slower path to economic recovery could also delay improved performance in historically underperforming sectors such as small-cap and lower-quality equities.

An unusual dynamic is influencing this environment. Recently, bad economic news has paradoxically become good news for stocks. Weak data has led investors to assume that it would push the Fed to cut rates, fueling stock rallies based on this premise. However, Wilson cautioned that this inverse correlation might unravel. If the Fed decides to adopt a more balanced or gradual approach to rate adjustments, the anticipated tailwinds for equities could dissipate.

Liquidity Challenges Could Amplify Risks

Liquidity conditions also play a crucial role in determining the market’s stability. Wilson expressed concerns about continued liquidity tightening due to the Fed’s ongoing balance sheet reduction, combined with rising Treasury and corporate bond issuances that are absorbing liquidity from the financial system. If liquidity becomes constrained, markets could face added pressures.

Wilson urged investors to keep an eye on key indicators such as the difference between the Secured Overnight Financing Rate (SOFR) and the federal funds rate, which tracks short-term borrowing costs, and the MOVE Index, a widely used measure of bond market volatility. “No major red flags have emerged yet,” Wilson noted, “but these indicators are critical for spotting early signs of liquidity distress.”

The Risk of a Market Shock Amid Liquidity Strains

Wilson concluded that the combination of subdued interest rate cuts and tightening liquidity could lay the groundwork for a market correction. Should the Fed fail to act on liquidity warning signs, equities may face unavoidable downward pressure. This is particularly true if liquidity challenges emerge at the same time as the market adjusts to slower-than-expected interest rate easing.

In summary, although certain market sectors show bullish sentiment, the fragile recovery remains highly sensitive to monetary policy decisions and liquidity conditions. Investors should prepare for heightened market turbulence if the Fed’s “normal judgment” diverges significantly from the baseline expectations baked into asset prices.