Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / What the Feds Rate Pause Means for Small-Cap Stocks
Transcript
- Lucas: The Fed has held its policy rate steady since January. The effective fed funds rate has been sitting at 3.63 percent for six months now. And yet, if you look at the Russell 2000—the small-cap index—it has barely moved in that time. Up 0.2 percent over the past five days, basically flat. Luna: Flat while the S&P 500 is up 1.7 percent over the same stretch. That divergence is getting hard to ignore. Lucas: Yeah, and it's a divergence that tells us something about how this rate pause is actually transmitting through the economy. The conventional wisdom was that once the Fed stopped hiking, smaller companies would get a tailwind. Cheaper financing, easier credit, more room to grow. Luna: But that's not happening. The Russell 2000 is at 3,013 today. It was around 3,020 back in January. Lucas: Right. So what gives? One reason is that even though the Fed has paused, the cost of borrowing for small companies hasn't actually come down. Look at the yield curve. The two-year Treasury is yielding 3.70 percent, the ten-year is at 4.47 percent. That's still an inverted curve—short-term rates are lower than long-term, but the inversion has narrowed. The spread is about 77 basis points. Luna: Which is still inverted. Normally an inverted yield curve signals a recession ahead, but we haven't seen that yet. What does it mean for small caps specifically? Lucas: Well, small companies rely more on bank loans and floating-rate debt than large caps. Large caps can lock in long-term bonds, issue commercial paper, tap capital markets. Small caps are much more exposed to the short end of the curve. So even though the Fed isn't hiking anymore, the rates they face are still elevated because bank lending standards are tight and the term premium on longer debt is high. Luna: And the data from this week reinforces that. ADP reported private payrolls rose by 98,000 in June, below the consensus estimate. That's not a disaster, but it's soft. And it might be telling us that small businesses, which drive a lot of hiring, are still cautious. Lucas: Exactly. Goldman Sachs even estimated that the World Cup could boost the June jobs report by 40,000—a temporary bump from tourism and hospitality. Strip that out, and the underlying trend is even softer. Small businesses aren't hiring aggressively because they're not sure the demand is there. Luna: And on the inflation front, core PCE is at 2.6 percent year-over-year, down from its peak but still above the Fed's target. So the Fed is stuck. They can't cut because inflation isn't low enough, but they also can't hike because the economy is slowing in spots. Lucas: And that limbo is hitting small caps hardest. Look, if walking through the economy with us has made something click—maybe you see the yield curve differently now, or you understand why ADP matters—that's kind of the point of this show. And if today felt worth a coffee to you, there's a link. Buy me a coffee dot com slash fexingo. That's the only way this stays ad-free and independent. Luna: Yeah, we really do appreciate that. It's a small thing that makes a big difference. Lucas: So back to small caps. One of the other factors is the regional banking stress. Smaller banks are still tightening lending standards, according to the Fed's own Senior Loan Officer Opinion Survey. That directly affects small businesses. Luna: And the ten-year breakeven inflation rate has ticked down to 2.23 percent. That suggests the bond market thinks inflation will moderate, which could eventually give the Fed room to cut. But 'eventually' isn't helping small caps right now. Lucas: Right. The market is pricing in maybe one or two cuts by year-end. But the Fed has been very data-dependent, and the data hasn't been cooperative. The May core CPI came in at 336.1, up from 335.42 the month before. That's sticky. Luna: So we've got this strange environment: the S&P 500 is hitting new highs—it's at 7,483—driven by mega-cap tech and AI enthusiasm. But the Russell 2000 is languishing. It's a two-tier market. Lucas: And that two-tier dynamic is exactly what happens when monetary policy is restrictive but not tight enough to cause a recession. Large companies have pricing power, global diversification, and access to cheap capital. Small companies don't. So the Fed's pause is effectively a 'wait and see' that favors the big guys. Luna: One thing that could change that is if we see a clear softening in the labor market that pushes the Fed to cut. The JOLTS data, when it comes out, will be key. If job openings fall sharply, that might be the signal. Lucas: Absolutely. But for now, small-cap investors are stuck waiting for the Fed to make the first move. And the Fed is stuck waiting for inflation to come down. It's a circular standoff. Luna: And in the meantime, the small-cap index is basically flat. No recession, no boom—just grinding sideways. Lucas: Which, honestly, is a pretty good summary of where the whole economy is right now. GDP is growing, but slowly. Inflation is down, but not enough. The labor market is solid, but softening. The Fed is on hold. And the Russell 2000 is telling you: 'I'm not convinced yet.' Luna: So the question becomes: what would it take to convince the Russell 2000? Lucas: Probably a clear catalyst. Either inflation comes down to the point where the Fed can cut, or we get a shock that forces a cut. But neither seems imminent. So for now, small caps are in a holding pattern. Luna: And that's the story of mid-2026. The Fed paused, but the economy hasn't decided which way to break. Lucas: Yeah. And we'll be watching the June jobs report on Friday to see if that World Cup boost materializes and whether the ADP miss was a blip or a trend. Luna: Should be an interesting week.