Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The Small Cap Rally That Markets Are Ignoring
Transcript
- Lucas: So the Russell 2000 is up over 3% in the last five days. That's almost three times the gain in the S&P 500 and nearly double the Nasdaq's return. And yet, if you look at most headlines, it's all about consumer sentiment hitting a record low and the Iran war rattling energy markets. Luna: That's a pretty big divergence. What's driving small caps while everyone else is still staring at inflation and geopolitics? Lucas: It's a rotation, plain and simple. Money is leaving big tech — the mega-cap names that led the market for the last two years — and moving into value-oriented small caps. The Russell is up 3.4% this week. The S&P 500 gained just 1%. The Dow, which has more industrial and financial exposure, is up 1.8%. That's a clear pattern. Luna: And what's the trigger? Is it the Fed holding rates steady, or something else? Lucas: That's the interesting part. The Fed funds rate is still at 3.62%, and the effective rate hasn't budged since March. But the two-year Treasury yield is at 3.59% — almost exactly the same as the fed funds rate. And the ten-year is at 4.56%. That's a steep curve, but the short end is signaling that the market expects a cut. Luna: So the bond market is saying the Fed will cut, but the economy is growing at 2% annualized real GDP. That's not exactly recession territory. Lucas: No, it's not. In fact, real GDP growth accelerated from 0.5% at the end of last year to 2% in the first quarter of 2026. But here's the catch: core CPI is still at 335.4, up from 334.2 in March. Inflation is sticky. The ten-year breakeven is at 2.4% — that's above the Fed's 2% target. So you have a growing economy with persistent inflation, and yet the market is pricing in rate cuts. Luna: That sounds like the classic stagflationary setup, except growth is actually okay. What gives? Lucas: I think the bond market is looking past the current data and seeing a slowdown later this year. Consumer sentiment hit a record low in May. The Iran war is pushing up energy costs. Job openings dropped from 6.9 million to 6.87 million — not a collapse, but a trend. And the housing market is still under pressure from rates above 4.5% on the ten-year. Small caps are more sensitive to domestic growth and borrowing costs, so if rates come down, they benefit disproportionately. Luna: So the small cap rally is a bet on rate cuts and a soft landing? Lucas: Exactly. But here's the risk: if inflation doesn't cool enough, the Fed can't cut. And then small caps, which are more leveraged and have thinner margins, get hit harder than the big tech names that have piles of cash. Luna: Speaking of which, I was looking at the weekly performance of the S&P sectors — financials and industrials are up about 2% each. That's part of the same rotation, right? Lucas: Absolutely. Banks benefit from a steep yield curve, which we have — the spread between the ten-year and the two-year is almost 100 basis points. That's a healthy environment for lending. And industrials are tied to domestic manufacturing, which is getting a boost from reshoring and ai related infrastructure spending. So the small cap rally is really a bet on the domestic economy, not just on rate cuts. Luna: Right, because if the economy is growing at 2%, that's not terrible. But the consumer sentiment data is really bad. How do you square those two things? Lucas: It's the classic 'vibecession' — people feel terrible about the economy even when the numbers are okay. Real GDP is $24.2 trillion, up from $24 trillion. Employment is at 158.7 million, a record high. But inflation has eroded purchasing power. The average hourly earnings are $37.40, up from $37.35 last month, but that's not keeping pace with the cost of rent and groceries. So consumers are grumpy, but they're still spending. Luna: And that's kind of the Fed's nightmare, right? How do you cut rates when inflation is still above target and the economy is growing? Lucas: Right. The Fed is stuck. If they cut too soon, inflation reaccelerates. If they hold, they risk choking off the expansion. The market is betting they cut because it wants lower rates, but the data doesn't support it yet. Luna: So what's the signal for a listener with a portfolio? Should they be piling into small caps now? Lucas: I think the rally has more room if rates do come down. But I'd be careful. Small caps are volatile, and the Russell is still down from its highs a few years ago. It's more of a tactical trade than a long-term buy and hold right now. The key is watching the ten-year yield — if it breaks below 4%, that would be a strong signal that the bond market expects a cut, and small caps could run further. Luna: That makes sense. So it's about the direction of rates, not just the level. Lucas: Exactly. And that's why this week's move is worth paying attention to — it's not just a random rotation. It's the market positioning for a policy shift that hasn't happened yet. If you're tracking the macro, the small cap index is telling you more than the S&P 500 right now. Luna: And speaking of tracking the macro – I know a lot of our listeners really appreciate how we break these numbers down without the jargon. Lucas: Yeah, that's the whole idea. We try to make sense of the data so you can actually use it. And if that's been helpful, listeners can support the show at buy me a coffee dot com slash fexingo. It keeps this thing ad-free and independent. Luna: Totally. No pressure, just if you get value from it. We really appreciate it. Lucas: Alright, back to the rotation. One other thing I'm watching: the Nasdaq is still up 1% this week, so it's not like tech is crashing. But the money flowing into small caps suggests investors are broadening out. They're saying the AI trade is getting crowded, and they want exposure to other parts of the economy. Luna: Especially if the AI buildout actually benefits industrial companies and the power grid. That's a theme we've touched on before. Lucas: Right. And that's a real structural story. But in the short term, it's about rates. So here's my takeaway for the week: the Russell 2000 is sending a signal. Don't ignore it just because the headline data is confusing. The bond market and the small cap market are both telling you that the next move from the Fed is down. Whether they're right is another question. Luna: And we'll be watching. Thanks, Lucas. Lucas: Thanks, Luna. See everyone next time.