Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the Small-Cap Rally Right Now
Transcript
- Lucas: The Russell 2000 is up more than three percent in the last five days. That is the biggest weekly gain for small caps since early April, and it is happening while the S&P 500 is barely up and the Nasdaq is actually down. Luna: So small caps are suddenly leading. That is a pretty sharp reversal from the narrative we have been hearing all year — that the rally was narrow, concentrated in mega-cap tech. Lucas: Exactly. And the Fed is watching this. Because when small caps outperform, it usually signals that investors are betting on lower rates, easier credit, and a soft landing. The question is whether this week's move is a genuine signal or just a catch-up trade. Luna: Well, and the timing is interesting. We just got wholesale prices up 1.1% in May, driven by energy. That is hot. That is not the kind of data that normally triggers a risk-on rally. Lucas: Right — and the ten-year yield actually fell about 14 basis points over the same period. So the bond market is reading the wholesale number as an energy spike, not a demand-driven inflation problem. And that is exactly the kind of nuance the Fed cares about. Lucas: If the bond market is telling you that inflation expectations remain anchored, and the rally in small caps is saying credit conditions are loosening, then the Fed has more room to hold or even cut. But if that small-cap rally is just a reflex from short-covering or momentum chasing, the signal breaks down. Luna: Let's talk about what actually drives small caps. They are more sensitive to domestic economic conditions, they carry more floating-rate debt, and they tend to be less profitable. So lower rates matter a lot to them. Lucas: Yeah. Small caps have a higher cost of capital exposure. Roughly 40% of the Russell 2000 by market cap has negative earnings. So when the Fed cuts, it is a direct liquidity boost to companies that are burning cash. That is why the rally sometimes precedes a pivot. Luna: But we are not at a pivot yet. The fed funds effective rate is 3.63%, and the daily rate is 3.62%. We are still in restrictive territory. So the market is pricing in cuts that the Fed has not signalled. Lucas: That is the tension. The small-cap rally is essentially betting that the Fed will cut sooner or deeper than the dot plot suggests. And historically, that bet has been right about half the time. The other half, it is a trap — the rally reverses when the Fed pushes back. Luna: So what does the data say right now? Core PCE is running at 2.8% annualized, CPI is at 4.2% headline. That is still above target. And the ten-year breakeven inflation rate just ticked up to 2.31%. Lucas: Right, and that is the part that complicates the story. If the Fed sees inflation expectations drifting higher, they cannot afford to cut just because small caps are rallying. They have to follow the inflation data. And right now, the inflation data is sticky. Lucas: But here is the thing — the move in small caps is happening alongside a drop in the two-year yield and a flat fed funds rate. That is a classic easing signal from the bond market. The market is effectively doing the Fed's job for them, tightening financial conditions by pricing in lower rates. Luna: And that might be exactly what the Fed wants. If the market eases conditions on its own, the Fed does not have to move. They can stay patient. Lucas: Exactly. And that is why this small-cap rally is worth watching. It is not just a sector rotation. It is a reflection of how the market is interpreting the interplay between inflation, growth, and Fed policy. If the rally sustains, it could become self-fulfilling — easier financial conditions, more economic activity, which then feeds back into inflation. Luna: And that feedback loop is exactly what the Fed is trying to avoid. They want to ease only when they are sure inflation is sustainably coming down. Lucas: So the question for this week is whether the small-cap rally is a genuine leading indicator or just a head fake. And the best way to track that is to watch the credit markets. If high-yield spreads are tightening, if banks are lending more, then the rally has legs. If it is just a technical move, it will fade. Luna: And the Fed will be watching the same things. They have access to the same data we do, but they also have the supervisory data from banks. They will know if credit is actually flowing before the rest of us. Lucas: One last thought — the energy piece. Wholesale prices rose 1.1% in May, almost entirely because of energy. That is a supply shock, not a demand shock. The Fed can look through that, especially if the ten-year breakeven stays below 2.5%. But if energy feeds into core services — think transportation costs, logistics — then it becomes a problem. Luna: So the small-cap rally is a vote of confidence in the soft landing, but it is a fragile vote. It depends on the Fed being right about inflation being transitory in the energy sector. Lucas: And on the market being right about the Fed cutting. Two big uncertainties. That is what makes this moment interesting. Luna: If walking through the economy with us has made something click over the past 53 episodes, a few listeners keep this whole thing rolling through buy me a coffee dot com slash fexingo. No ads, no sponsors — just people who find this kind of conversation useful. Lucas: Yeah, it is a small group, but it makes a big difference. It is what lets us keep doing deep dives like this without having to chase clicks or ad revenue. So if you are someone who gets value out of these episodes, that is the place to chip in. Luna: Alright. Back to the data. So we have the small-cap rally, the bond market easing, the energy spike — how do you see the Fed processing all of that ahead of the July meeting? Lucas: I think they will wait. The May CPI and wholesale numbers came in hot, but the bond market is telling them the heat is mostly in energy. If the June data shows that energy is rolling over and core inflation is still decelerating, they will have room to cut in September. Luna: So the small-cap rally might be pricing in a September cut. That is consistent with the move we are seeing. Lucas: It is. But the market has been early before. Remember what happened in January of this year — the market priced in four cuts, the Fed pushed back, and small caps sold off 8% in February. Luna: Right. So we are in a waiting game. The next big data point is the June CPI, due out July 11. That will tell us whether the energy spike is spilling into core. Lucas: And until then, the small-cap rally is a signal, but not a sure thing. It is a bet on the Fed, not a confirmation. We will keep an eye on it. Luna: Good. That is what we do. Thanks for listening.