Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Small Caps Are Roaring as the Fed Holds Steady
Transcript
- Lucas: The Russell 2000 just put up its best week in months — up three point four percent over the past five trading days. And that's happening while the Fed is parked at three point six four percent and consumer sentiment is at an all-time low. Luna: It's a weird signal, right? Small caps are supposed to be the most rate-sensitive part of the market, and yet they're rallying while the big indexes are just drifting. Lucas: Exactly. The S&P 500 is up one percent over the same stretch. The Dow is up one point eight. But the Russell — that's a different animal. It's almost like the market is pricing in something the macro data isn't saying yet. Luna: Are we talking about a pivot narrative? Because the bond market doesn't look like it's expecting a cut anytime soon. The ten-year is at four point five six percent — down a bit from last week, but still elevated. Lucas: Yeah, and that's the interesting tension. The ten-year yield actually fell one point four percent this week. So bonds are rallying, small caps are rallying, but consumer sentiment is cratering. The latest read hit a fresh record low — and the headline from CNBC directly ties it to the Iran conflict and inflation worries. Luna: So the market is looking past the current gloom and betting on something better ahead? Or is this just a rotation out of big tech into smaller names? Lucas: I think it's partly rotation. The NASDAQ is up only one percent this week — same as the S&P. But the Russell's three point four percent gain suggests real money is moving. And there's a narrative forming around the AI economy potentially benefiting smaller, more agile companies rather than just the mega-cap names. Luna: There was that CNBC piece this week about how the AI economy is rewriting the American Dream and blue-collar workers are poised to win. That's a very different story from the 'AI kills jobs' narrative we heard last year. Lucas: Right. And if you connect that to small caps, a lot of those companies are in manufacturing, logistics, construction — sectors that could see productivity gains from AI adoption without the massive layoffs that the tech giants are doing. So maybe the market is starting to price that in. Luna: But the Fed is still the elephant in the room. Kevin Warsh was sworn in as chair this past Friday, and the effective federal funds rate is at three point six four. No movement there. Lucas: And the interest on reserve balances is at three point six five, which is basically the top of the target range. So the Fed is signaling no urgency to cut. But the market is rallying anyway. Luna: Let's talk about the breakeven inflation rate. The ten-year breakeven ticked up to two point four percent this week from two point three nine. That's still below the recent peak, but it's creeping higher. Does that worry you? Lucas: A little. The core CPI came in at three hundred thirty-five point four for April, up from three hundred thirty-four point one seven. So inflation is still sticky. And the PCE price index, which the Fed prefers, also ticked up in March. If breakevens keep rising, the Fed will have a hard time cutting even if consumer sentiment is in the toilet. Luna: It feels like we're in a regime where bad news for consumers is good news for rates — but only up to a point. If inflation expectations become unanchored, then the Fed would have to tighten, and that would crush the small-cap rally. Lucas: Exactly. And that's the tightrope Warsh is walking. He's inheriting a bond market that already tested him before he even took the job. The vigilantes are watching. Luna: Before we go deeper into that — I want to mention something quickly. If today's episode was useful to you and you want to keep it ad-free, buy me a coffee dot com slash fexingo helps. Really straightforward. Lucas: Yeah, it's a small thing that makes a big difference for us. And we mean that. Back to the bond market — the two-year yield is at three point five nine percent, which is actually up half a percent this week. That's the short end rising while the long end falls. That's a steepening curve. Luna: Steepening typically means the market expects growth or inflation down the road. But with consumer sentiment at a record low, that seems contradictory. Lucas: Unless the market thinks the consumer sentiment numbers are backward-looking. The survey was taken during a period of heavy Iran war headlines, and sentiment is notoriously reactive to news. Meanwhile, actual spending data might hold up better. We'll get more clarity when the next PCE and CPI prints come out. Luna: So what's your takeaway for someone trying to position their portfolio right now? The Russell is up, but is it a trap? Lucas: I think it's a tactical opportunity, but not a buy and forget. If the Fed holds steady through the summer, and inflation doesn't reaccelerate, small caps could keep gaining. But if the Iran situation escalates further and oil spikes, that's a direct hit to the earnings of smaller companies with less pricing power. Luna: And the geopolitical wildcard is real. The Putin-Xi talks this week about reviving a Russian gas pipeline — that's energy markets shifting in real time. If European gas prices drop, that could ease inflation globally, which would be a tailwind for small caps. Lucas: Right. And there's the uk gulf trade deal being called a 'monumental achievement'. Trade realignments are happening. Small caps that are domestically focused might benefit from less global competition. It's a complex picture. Luna: One last thing — we talked about the AI economy and blue-collar workers. Is there a specific small-cap company or subsector you're watching? Lucas: I'm keeping an eye on the industrial automation and logistics software space. Companies that help factories and warehouses become more efficient without replacing workers. That's where the AI adoption story meets the small-cap reality. But I don't want to name names — these are volatile stocks. Luna: Fair enough. So to summarize: small caps are rallying on a mix of rotation, AI optimism, and a steepening yield curve. But consumer sentiment is awful, inflation is sticky, and the Fed is on hold. It's a market that's pricing in a soft landing, but the data hasn't confirmed it yet. Lucas: That's exactly it. The next few weeks — with the next CPI and PCE reports — will tell us whether the Russell rally has legs or if it's just a bear market bounce in disguise. We'll be watching. Luna: Thanks for listening. We'll be back soon with more on the Fed, the economy, and the markets.