Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why Small Caps Are Outperforming as the Fed Holds Steady
Transcript
- Lucas: The Russell 2000 is up 3.4 percent in the past five trading days. The S&P 500? Up just one percent. That's a striking divergence, and it's happening while the Fed holds rates exactly where they've been since January. Luna: Three point six four percent on the effective fed funds rate. Stuck. And yet the market is pricing in a pretty good chance of cuts by September. Do the small caps know something the rest of the market doesn't? Lucas: That's exactly the question. Small caps are domestically oriented—they borrow in dollars, they sell to American consumers, they're more sensitive to interest rates than the big multinationals that dominate the S&P 500. So when the Russell rallies like this, it's usually a signal that investors expect lower rates ahead. Luna: Right, because cheaper borrowing costs directly improve their earnings outlook. A big tech company can hedge its debt, issue bonds globally. A small manufacturer in Ohio? Not so much. Lucas: Exactly. So the small-cap rally is essentially a bet that the Fed will cut. But here's the tension—core CPI came in at 335.4 in April, up from 334.17 in March. That's not moving in the right direction for a dovish Fed. Luna: And the ten-year breakeven inflation rate ticked up to 2.40 percent. That's still above the Fed's target, even if only marginally. So the market is betting on cuts, but the inflation data isn't cooperating. Lucas: Kevin Warsh gave a speech two weeks ago—his first major remarks since taking the helm—and he made it pretty clear that he's watching inflation expectations like a hawk. He's not going to cut until he sees sustained progress on core PCE. Luna: And core PCE is still at 129.3, up from 128.9. That's a month-over-month increase. Not exactly the kind of data that screams 'mission accomplished'. Lucas: So you have this disconnect. The small-cap rally is telling you that the market expects the Fed to blink. But the data says the Fed can't blink yet. Something has to give. Luna: Which side do you lean on? Is the market getting ahead of itself, or is the Fed about to be forced into a cut by something else—like a sharp slowdown? Lucas: If you look at consumer sentiment, it hit a fresh record low last week. That's partly the Iran war rattling energy prices, but it's also cumulative inflation fatigue. Americans feel squeezed. If that shows up in spending data, the Fed might have to act even if inflation isn't all the way back to two percent. Luna: So the small caps might be pricing in a 'growth scare' cut, not a 'victory over inflation' cut. That's a different kind of rally. Lucas: Exactly. And that's fragile. Because if the economy slows but inflation stays sticky—stagflation-lite—then small caps get hit from both sides: earnings drop and the Fed can't ride to the rescue. Luna: We've seen this movie before. 2022. Small caps got crushed when the Fed kept hiking. Lucas: Yeah, but the difference now is that the Fed is already paused. The question is whether that pause lasts six more months or whether something forces their hand sooner. Luna: Let's talk about what would actually force their hand. What's the trigger? Lucas: Two things. One: a sharp deterioration in the labor market. The JOLTS data has been softening, but we're not seeing mass layoffs yet. If that changes, the Fed will cut regardless of inflation. Two: a credit event. If something breaks in the banking system or the commercial real estate market, the Fed will step in. Luna: Commercial real estate has been a ticking time bomb for a while. Higher rates have crushed valuations, and a lot of debt needs to be refinanced this year. Lucas: Right. And regional banks are exposed. That's actually another reason small caps might be interesting here—they're more tied to regional banks than the big banks that serve large corporates. If regional banks tighten lending, small caps feel it directly. Luna: So the rally could be a head fake. They're pricing in cuts, but if cuts come because of a crisis, the rally might not last. Lucas: Or it could be the real deal if the economy reaccelerates and inflation drifts lower. But right now, the data doesn't support that. Core CPI is still moving up, not down. Luna: Let's zoom out for a second. The yield curve has been inverted for a long time—the two-year yield is still above the ten-year. That's a classic recession signal. But small caps are rallying. Lucas: And the ten-year yield has actually fallen 2.3 percent in the last five days, to 4.56 percent. That's a big move. Lower long-term yields help small caps because they discount future cash flows at a lower rate. So part of the rally is just a mechanical response to the bond market. Luna: But the two-year yield is still at 3.58 percent, and that's barely changed. So the curve is still inverted, but it's less inverted than it was. The spread is narrowing because long-term yields are falling faster. Lucas: That's actually a classic pattern before a recession—the curve 'un-inverts' as the market prices in rate cuts. So the small-cap rally might be the market saying 'recession is coming, and the Fed will cut'. But that's not necessarily bullish for stocks over the next six months. Luna: Unless the recession is very mild and the cuts come fast. The market always tries to look through the downturn. Lucas: And right now, the market is looking through to a world where the Fed cuts maybe twice before year-end. Let's check the fed funds futures. They're pricing in about 50 basis points of cuts by December. That's not nothing, but it's not a panic move either. Luna: So the small caps are up 3.4 percent in a week on the hope of 50 basis points of cuts. That's a lot of enthusiasm for a relatively modest policy change. Lucas: It is. And that's why I'm a little skeptical. If the cuts don't materialize—if inflation stays sticky—the Russell could give back those gains quickly. Small caps are volatile. Luna: What's your base case? Where do you think rates end the year? Lucas: I think the Fed stays on hold until at least September. By then, we'll have a few more months of CPI and PCE data. If core inflation is still above 3 percent, they'll hold into 2027. If it drops below 2.5 percent, they might cut once. But I don't see a dramatic easing cycle unless something breaks. Luna: And if something breaks? Say commercial real estate triggers a regional bank crisis? Lucas: Then all bets are off. They'd cut aggressively. But that's not the base case. The base case is slow, grinding inflation, and a Fed that's in no rush. Luna: That feels like a tough environment for small caps. High rates for longer, slowing economy, still-high inflation. Lucas: It's definitely not a tailwind. But small caps are cheap relative to large caps. The price to earnings ratio on the Russell is about 15, compared to 22 on the S&P 500. So there's a valuation argument for owning them, even if the macro is uncertain. Luna: Value play. You buy when they're out of favor and wait for the cycle to turn. Lucas: Exactly. And that's what some investors are doing. But it requires patience. The rally this week could be just a positioning squeeze—shorts covering—rather than a fundamental shift. Luna: Speaking of patience, keeping a podcast like this going without ads takes a different kind of patience. Just a handful of listeners chip in monthly through Buy Me a Coffee dot com slash fexingo, and that's literally what funds us making as many of these as we do. Lucas: Yeah, it's not a big ask—it's just a way for people who get value from the show to help keep it ad-free. If that's you, you know where to find it. And if not, no worries at all. We're glad you're here either way. Luna: Now, back to small caps. You mentioned the valuation gap. How wide is it historically? Lucas: The current spread between the Russell's P/E and the S&P 500's P/E is about 7 points. The historical average is closer to 3 or 4. So small caps are unusually cheap relative to large caps. That doesn't guarantee outperformance, but it does suggest that a lot of bad news is priced in. Luna: So if the economy avoids a recession, small caps could have a lot of upside. Lucas: Exactly. And if we get a soft landing—where inflation falls without a sharp rise in unemployment—small caps could rally significantly. The question is whether that's possible with the fed funds rate at 3.64 percent and core CPI still rising. Luna: We've had a soft landing before. 1995. The Fed cut rates gradually, and small caps did well. Lucas: That's the bull case. But the current situation has some differences. Inflation is stickier now. And the geopolitical backdrop is more complicated—the Iran war is putting upward pressure on energy prices. That's a headwind for both the economy and corporate profits. Luna: So small caps are caught between a cheap valuation and a messy macro. That's why you're seeing such divergent opinions on them right now. Lucas: Yeah, it's a real tug of war. And the next few months of data will determine which side wins. Luna: Small caps, rates, inflation—it all ties together. Thanks for breaking it down. Lucas: Always. We'll keep watching the Russell—and the Fed—and bring you what we see.