U.S. Economy: Solid Footing For Now, Uncertainty Ahead

Summary

Podcast Summary: "U.S. Economy: Solid Footing For Now, Uncertainty Ahead"

Thoughts on the Market
Host: Morgan Stanley
Episode Title: U.S. Economy: Solid Footing For Now, Uncertainty Ahead
Release Date: May 6, 2025

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Introduction

In this episode of Thoughts on the Market, Morgan Stanley hosts Matthew Hornbach, Global Head of MacroStrategy, and Michael Gapen, Chief U.S. Economist, to discuss the current state of the U.S. economy, the implications of the recent Federal Open Market Committee (FOMC) meeting, and the evolving dynamics of the treasury market. The conversation delves into the solid foundations of the economy, upcoming challenges, and investor reactions to recent economic indicators.

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Current State of the U.S. Economy

Michael Gapen begins by assessing the broader economic landscape:

“[00:41] Michael Gapen: Yeah, I think right now, Matt, I would say the economy is still on relatively solid footing...”

Despite a slight moderation, the economy remains robust. The first-quarter GDP saw a negative print, primarily due to a significant increase in imports—over 40% on an annualized basis—used for inventory and business spending, which acted as a mechanical drag on activity. The labor market remains strong, with average job additions slowing to about 145,000 per month in 2025 from 170,000 in the latter half of the previous year. Importantly, there are no signs of a sharp slowdown or a rise in layoffs.

However, uncertainty looms, particularly due to geopolitical events like Liberation Day. Gapen highlights:

“[02:16] Michael Gapen: ...Liberation Day...puts a lot of uncertainty in front of us. It risks a sudden shock to the economy and we risk a sudden stop in trade volume.”

While the economy currently stands on solid footing, upcoming concerns include potential trade disruptions and rising inflation, necessitating cautious monitoring.

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FOMC Meeting Expectations

The discussion shifts to the anticipated outcomes of the ongoing FOMC meeting:

Matthew Hornbach sets the stage by referencing New York Fed President John Williams' recent projections, which align closely with Gapen’s outlook:

“[02:38] Michael Gapen: ...John tends to be one of the kind of a median participant...”

Williams projects GDP growth slowing to below 1% in 2025, inflation rising to between 3.5% and 4% for the year, and unemployment hovering between 4.5% and 5%. These projections mirror Morgan Stanley’s expectations, suggesting the Fed shares similar economic concerns.

Gapen anticipates the Fed’s main message to be a stance of patience:

“[03:49] Michael Gapen: ...the Fed's main message this week will be that they're prepared to wait, that they think policy is in a good spot right now.”

The Fed is likely to emphasize the need for clarity on whether the current inflationary pressures are temporary or persistent, maintaining a position of inaction unless economic indicators, such as the labor market, show signs of weakening. However, Gapen warns that the Fed may adopt a more hawkish tone than markets expect, potentially catching investors off guard.

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Treasury Market Dynamics

Transitioning to the treasury market, Matthew Hornbach reflects on recent unusual behaviors:

“[05:23] Matthew Hornbach: ...US Treasuries didn't act like the safe haven asset many have come to expect...”

Despite traditional expectations, treasury yields initially fell post-Liberation Day but then rose sharply over the past month. Hornbach draws parallels to the Great Financial Crisis and the early stages of the COVID-19 pandemic, suggesting that systemic uncertainty prompted investors to reduce duration risk—selling longer-term bonds in favor of shorter maturities.

Gapen observes discrepancies between market expectations and economic forecasts:

“[07:09] Michael Gapen: So, Matt, one aspect of market pricing that stands out to me is how rates markets are pricing 75 basis points of rate cuts this year...”

While the market had previously priced in approximately 100 basis points of rate cuts after April 2, current projections—endorsed by Gapen—do not support such aggressive reductions. Hornbach explains that market pricing represents an aggregation of diverse scenarios, making it challenging to isolate and adjust to a single baseline expectation.

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Market Pricing and Yield Curve Expectations

Matthew Hornbach discusses his conviction in the rates market, emphasizing the likelihood of a steepening yield curve by December 2025:

“[09:13] Matthew Hornbach: ...we have the highest conviction in terms of what happens with the treasury market this year is we have a steeper yield curve by the time we get to December.”

This expectation is based on the anticipated divergence between shorter and longer-term yields. As the Fed contemplates rate reductions in 2026, increased treasury supply driven by fiscal policies will pressure longer-term yields upward relative to shorter maturities.

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Conclusion

The episode wraps up with a synthesis of the key points:

• The U.S. economy remains on solid footing despite some moderating indicators.
• Upcoming geopolitical events like Liberation Day introduce significant uncertainty, potentially impacting trade volumes and economic stability.
• The Fed is likely to adopt a patient stance in its monetary policy, emphasizing the need to assess inflation trends before making further adjustments.
• Treasury market behaviors have deviated from historical norms, reflecting heightened uncertainty and shifts in investor risk appetites.
• Market expectations for rate cuts are more aggressive than Morgan Stanley’s projections, but alignment is expected to occur gradually as economic data unfolds.

Gapen and Hornbach offer a cautious yet optimistic outlook, emphasizing the importance of monitoring economic indicators and maintaining strategic flexibility in response to evolving market conditions.

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Notable Quotes

• Michael Gapen on Economic Footing:
  “I think right now, Matt, I would say the economy is still on relatively solid footing.”
  [00:41]

• Gapen on Liberation Day’s Impact:
  “Liberation Day...puts a lot of uncertainty in front of us. It risks a sudden shock to the economy and we risk a sudden stop in trade volume.”
  [02:16]

• Gapen on Fed’s Message:
  “...the Fed's main message this week will be that they're prepared to wait, that they think policy is in a good spot right now.”
  [03:49]

• Hornbach on Treasury Market Behavior:
  “I think investors were paring back duration risk, which helped the US treasury market perform pretty poorly at one moment over the past month.”
  [05:23]

• Hornbach on Yield Curve:
  “...we have the highest conviction in terms of what happens with the treasury market this year is we have a steeper yield curve by the time we get to December.”
  [09:13]

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This comprehensive summary encapsulates the critical discussions and insights shared by Morgan Stanley’s Matthew Hornbach and Michael Gapen, providing listeners and non-listeners alike with a clear understanding of the current economic landscape and future outlook.

Transcript

[Matthew Hornbach]

Welcome to Thoughts on the Market. I'm Matthew Hornbach, global head of MacroStrategy.

[Michael Gapen]

And I'm Michael Gapen, Morgan Stanley's chief U.S. economist.

[Matthew Hornbach]

Today we're talking about the Federal Open Market Committee meeting underway and the path for rates from here. It's Tuesday, May 6th at 10:00am in New York. Mike, before we talk about your expectations for the FOMC meeting itself, I wanted to get your take on the US Economy heading into the meeting. How are you seeing things today and in particular, how do you think what happened on April 2, so called Liberation Day, affects the outlook?

[Michael Gapen]

Yeah, I think right now, Matt, I would say the economy is still on relatively solid footing. And by that I mean the economy had been moderating. Yes, the first quarter GDP print was negative, but that was mainly because firms were frontloading a lot of inventories through imports. So imports were up over 40% at an annualized pace in the quarter. A lot of that went into inventories and into business spending. That was just a mechanical drag on activity. And the April employment report, I think showed the same thing. We're now averaging about 145,000 jobs per month this year. That's down from about 170,000 per month in the second half of of last year. So the hiring rate is slowing down, but no signs of a sudden stop, no signs in layoffs picking up. So I'd say the economy is on fairly solid footing and the labor market is also on fairly solid footing as we enter the period now when we think tariffs will have greater effect on the outlook. So you asked Liberation Day, how does that affect the outlook right now? We'd say it puts a lot of uncertainty in front of us. It risks a sudden shock to the economy and we risk a sudden stop in trade volume. So the economy is on pretty solid footing now. But Matt, looking forward, we have a lot of concerns about where things may go and we expect activity to slow and inflation to rise.

[Matthew Hornbach]

That's great background, Mike, for what I want to ask you about next, which is of course the FOMC meeting this week. We won't get a new set of from the committee, but if we did, what do you think they would do with them and how would you assess the reaction function? One might be able to tease out of those economic projections.

[Michael Gapen]

You're right. We don't get a new set of projections. But New York Fed President John Williams did provide some indication about how he adjusted his forecast. And John tends to be one of the kind of a median participant. He tends to be centrist in his thinking and his projection. So I do think that that gives us an indication of what the Fed is thinking. And he said he expects GDP growth to slow to somewhat below 1% in 2025. He expects inflation to rise to 3.5 to 4% this year. And he said the unemployment rate is likely to move between 4 and a half and 5% over the next year. And those phrases are really key. That's the same thing, Matt, as you know, we are expecting for the US Economy. And I do think the Fed is thinking of it the same way.

[Matthew Hornbach]

So one final question for you, Mike. In terms of this meeting itself, what are you expecting the Fed to deliver this week, and what are the risks you see around that expectation? You know what might catch investors off guard?

[Michael Gapen]

I think the Fed's main message this week will be that they're prepared to wait, that they think policy is in a good spot right now. They think inflation will be rising sharply, that the tariff shock is a lot larger than they had anticipated earlier this year, and they will need time to assess whether that inflation impulse is transitory or whether it creates more persistent inflation. So I think what they will say is we're in a good position to wait and we need clarity on the outlook before we can act. In this case, we think acting means doing nothing. But acting could also mean cutting if the labor market weakens. So I think they'll be worried about inflation today, a weak labor market tomorrow. And so I think risks around this meeting really are tilted in the direction of a more hawkish message than markets are expecting, at least vis a vis current pricing. I think the market wants to hear the Fed will be ready to support the economy. Of course we think they will. But I think the Fed's also going to be worried about inflation pressures in the near term. So that, I think might catch investors off guard. So, Matt, what I think might catch investors off guard may be a little misplaced. I'm an economist, after all. You're the strategist. You're the expert on the treasury market and how investors may be perceiving events at the moment. So the treasury market had quite the month since April 2nd. For a moment, US Treasuries didn't act like the safe haven asset many have come to expect. What do you think happened?

[Matthew Hornbach]

So, Mike, you're absolutely right. Treasury yields initially fell, but then spent a healthy portion of the last month rising. And investors were caught off guard by what they saw happening in the treasury market. I've seen this type of behavior in the treasury market which I've been watching now for 25 years. I've seen this happen twice before in my career. The first time was during the great financial crisis. And the second time I saw it was in March of 2020. So this being the third time, you know, I don't know if it was the charm or if it was something else, but treasury yields went up quite a bit. I think what investors were witnessing in the treasury market is really a reflection of the degree of uncertainty and the breadth with which that uncertainty traversed the world. Both the great financial crisis and the initial stage of the pandemic in March of 2020 were events that in nature, they were in many ways systemic in nature, and they were events that most investors hadn't contemplated or seen in their lifetimes. And when this happens, I think investors tend to reduce risk in all of its forms until the dust settles. And one of those very important forms of risk in the fixed income markets is duration risk. So I think investors were paring back duration risk, which helped the US treasury market perform pretty poorly at one moment over the past month.

[Michael Gapen]

So, Matt, one aspect of market pricing that stands out to me is how rates markets are pricing 75 basis points of rate cuts this year. And just after April 2, the market had priced in about 100 basis points of cuts. How are you thinking about the market pricing today, Matt? As you know, it differs quite a bit from what we think will happen.

[Matthew Hornbach]

Yeah, this is where understanding that market prices in the interest rate complex reflect the average outcome of a wide variety of scenarios, really every scenario that is conceivable in the minds of investors. And of course, as you mentioned, Mike, depending on exactly how this year ends up playing out, there could be a scenario in which we, the Federal Reserve, has to lower rates much more aggressively than perhaps even markets are pricing today. So the market, being an average of a wide variety of outcomes, will find it really challenging to take out all of the rate cuts that are priced in today or said differently. The market will find it challenging to price in your baseline scenario. And ultimately, I think the way in which that market ends up truing up to your projections, Mike, is just with time. I think as we make our way through this year and the economic data come in in line with your baseline projections, the market will eventually price out those rate cuts that you see in there today. But that's going to take time. It's going to take investors growing increasingly comfortable that we can avoid a recession, at least in perception this year before on your projections, we have a bit of a slower economy in 2026.

[Michael Gapen]

Well, it definitely does feel like a bimodal world where investor conviction is low. Matt, where do you have conviction in the rates market today?

[Matthew Hornbach]

So the way we've been thinking about this environment where we can avoid a recession this year, but maybe 2026, the risks rise a bit more. We think that that's the type of environment where the yield curve in the United States can steepen. And what that means practically is that yields on longer maturity bonds will go up relative to yields on shorter maturity bonds. So you get this steepening of the yield curve. And that is where we have the highest conviction in terms of what happens with the treasury market this year is we have a steeper yield curve by the time we get to December. Now, part of that steepening, we think, comes because as we approach 2026, where, Mike, you have the Fed beginning to lower rates in your baseline, the market will have to increasingly price with more conviction a lower policy rate from the Fed. But then at the same time we probably will have an environment where treasury supply will have to increase as a result of the fiscal policies that the government is discussing at the moment. And so you have this environment where yields on longer maturity securities are pressured higher relative to yields on shorter maturity Treasuries. So with that, Mike, we'll wrap our conversation. Thanks so much for taking the time to talk.

[Michael Gapen]

It's been great speaking with you, Matt.

[Matthew Hornbach]

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