Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / What the Fed Makes of the Small-Cap Rally Right Now
Transcript
- Lucas: The Russell 2000 is up more than 3% in the last five trading days. The S&P 500 is basically flat. The Nasdaq is down a hair. So the smallest publicly traded companies in the country just had their best week relative to large caps in about nine months. Luna: And this is happening while inflation is running at 4.2% year-over-year and wholesale prices just surged more than expected. That seems backwards, doesn't it? Lucas: It does on the surface. But the market is pricing in something the Fed hasn't said out loud yet. If walking through the economy with us has made something click — if you find yourself looking at the yield curve differently or actually caring about the Russell versus the S&P — the way this stays ad-free and independent is listener support. Buy me a coffee dot com slash fexingo. That's it. No tiers, no perks, just keeping the show going. Now, let's talk about what the small-cap rally actually means. Luna: Yeah, that's a good way to put it. Because I think a lot of people see the Russell pop and assume it's just risk-on euphoria or whatever. Lucas: Right. But when you look under the hood, the story is more about rates than about animal spirits. The ten-year yield has dropped to 4.49%, down about 6 basis points in the last week. The two-year is at 4.21. So the gap between them — the term premium, the slope of the yield curve — has widened. Luna: A steeper curve historically favors small caps because they tend to be more levered to short-term borrowing costs and more dependent on a healthy economic expansion. Lucas: Exactly. Small companies don't have the pricing power or the balance sheets of an Apple or a Microsoft. They live and die by the spread between what they can borrow at and what they can earn. So when the yield curve steepens — when long-term rates stay higher than short-term rates but the gap widens — that's usually a signal that the market expects growth to hold up. Luna: But the CPI print this month was 4.2%. That's the highest in three years. And the wholesale price index rose 1.1% in May alone. How does that square with a soft-landing narrative? Lucas: It doesn't perfectly. And I think that's why this rotation is fragile. The market is essentially betting that this inflation spike is energy-driven and transitory — that the Fed doesn't need to hike again because the Iran conflict and the wholesale surge will fade. The ten-year breakeven inflation rate ticked up to 2.31% from 2.29% last week. That's not nothing, but it's not panic territory either. Luna: So the market is giving the Fed permission to stay on hold, essentially. Lucas: For now. The Fed funds rate is at 3.62%. The interest on reserve balances is 3.65%. There's no pressure to move in either direction from the overnight market. But the real question is whether small caps can sustain this rally if core services inflation doesn't cool off. Luna: Because the core PCE price index, which is the Fed's preferred gauge, is still running hot. April came in at 129.6, up from 129.32 in March. That's not a dramatic acceleration, but it's not decelerating either. Lucas: Right. And the Fed has been very clear: they need to see sustained progress on core PCE before they even think about cutting. So the small-cap rally is betting on a Goldilocks scenario — inflation comes down gently, the economy keeps growing, and the Fed eventually cuts in 2027. That's a plausible narrative, but it's not the only one. Luna: What's the bear case for small caps right now? Lucas: The bear case is that this is just a short-covering bounce in the most hated part of the market. Small caps got absolutely destroyed in 2025. The Russell 2000 was down something like 12% last year. So a 3% weekly rally after a prolonged downtrend is not confirmation of a new bull market. It could just be positioning. Luna: And positioning data does show that hedge funds were heavily short small caps going into June. Lucas: They were. So a lot of this move could be shorts getting squeezed. The real test will come in the next two weeks, when we get the June employment report and the next FOMC minutes. If the labor market stays tight and inflation doesn't moderate, the Russell could give back those gains just as fast. Luna: One thing that stands out to me is that the small-cap rally is coinciding with weakness in the Nasdaq. Tech stocks are down slightly on the week. That suggests money is rotating out of high-multiple growth and into value-oriented small caps. Lucas: That's a classic late-cycle rotation. When the market starts to doubt that tech can keep growing at 20% a year, it looks for cheaper alternatives. Small caps, on average, trade at about 15 times forward earnings right now. The S&P 500 is at 21. So there's a valuation gap that could close if earnings hold up. Luna: But small-cap earnings have been under pressure. The Russell 2000 companies are more exposed to domestic demand, and with consumer sentiment shaky — we saw that in the New York Fed household survey last month — it's not obvious that earnings will rebound. Lucas: That's the tension. The market is pricing in a recovery that hasn't shown up in the data yet. The May CPI report showed that consumer prices rose 4.2% annually, but the core reading was actually a tick higher than expected. And wholesale prices surged on energy. So input costs for small businesses are going up. Luna: And small businesses have less ability to pass those costs on to customers. Their margins get squeezed. Lucas: Exactly. So this rally is a bet on margin recovery, not a reflection of current reality. The Fed is watching this closely because if small caps start to falter, that could be a leading indicator for the broader economy. Small companies employ a huge share of the workforce. Luna: There's also the international angle. The UK economy just shrank 0.1% in April, partly because of the Iran conflict. The ECB hiked rates for the first time since 2023, also citing energy costs from that conflict. So global headwinds are building. Lucas: The US is somewhat insulated because we're a net energy exporter now, but we're not completely immune. If the Iran situation escalates further, energy prices could stay elevated, which would feed into wholesale and eventually consumer prices. That would put the Fed in a tough spot — do they look through energy-driven inflation or do they respond? Luna: The market seems to think they'll look through it. The ten-year yield is down, not up, despite the hot CPI and PPI prints. Lucas: That's the bond market's way of saying this inflation is transitory. But we've been burned by that narrative before. Remember 2021 and 2022? The Fed kept saying inflation was transitory, and then it wasn't. So I think the small-cap rally is a bet on Fed credibility — that they'll get it right this time. Luna: And if they don't? Lucas: If they don't, small caps get hit harder than large caps because they're more sensitive to interest rates. The Russell has a higher effective duration than the S&P 500. So a rate hike would be disproportionately painful for the companies that just rallied the most. Luna: But the Fed hasn't signaled any intention to hike. The effective fed funds rate has been flat at 3.62% for weeks. The dot plot from the last FOMC meeting showed no rate changes for the rest of 2026. Lucas: That's true. But the dot plot is not a promise. It's a projection. And projections change when the data changes. If the next CPI print comes in at 4.5% or higher, you'll see the market start pricing in a hike, and the Russell will be the first to sell off. Luna: So what's your takeaway for someone listening? Should they read anything into this small-cap pop? Lucas: I think the takeaway is that this is a signal worth watching, but not one to act on yet. The rotation tells us the market is positioning for a soft landing and a stable rate environment. But the inflation data hasn't confirmed it yet. Watch the June CPI and the next FOMC minutes. If the yield curve continues to steepen and small caps hold their gains, that's a constructive sign. If they give it all back, it was just a short squeeze in a bear market. Luna: And in the meantime, the Fed is probably watching the same thing we are, trying to figure out whether this rally is real or just noise. Lucas: Exactly. They're data-dependent, and this is one more data point. The Russell 2000 is telling us something. We just don't know yet if it's telling the truth.