Morgan Stanley still sees downside risk to financial markets, and warns that the credit crunch isn’t over yet. As a result, it sees lower interest rates ahead.

In a research note, the firm says that the U.S. Federal Reserve Board has already taken aggressive steps to provide support to financial markets, and the data suggests that the financial crisis peaked in mid-March. “Spreads on risky assets and in some money markets have narrowed,” it reports.

However, it maintains that financial market pressures are not over, “and a contracting economy may yet promote an ‘adverse feedback loop’ as it weakens the value of collateral, forces lenders to deleverage and raise capital, and thus further tightens credit availability.”

While risk spreads are narrower than they were three weeks ago, it notes that they have widened by 25-30 basis points over the past week, and funding pressures have resurfaced in money markets. “To be sure, some of these reversals corrected price action that may have moved too far and too fast,” it says. “More fundamentally, however, we think that they reflect the pressure from ongoing losses on lenders’ balance sheets and the associated concerns about counterparty risk. Those pressures seem likely to prolong the credit crunch or even intensify it.”

As a result, it expects that the Fed will ease further and maintain an accommodative stance through late this year. It predicts that the Fed will reduce the funds rate by another 50 bps to 1.75% at this month’s FOMC meeting, and maintain that lower rate until late this year.