As we have discussed previously, investors are potentially rotating from large-cap to small-cap stocks in anticipation of a more favorable monetary policy environment. Smaller companies typically are sensitive to high borrowing costs because they carry heavier debt loads with floating interest rates compared to large caps. We discussed more about the recent Russell 2000 outperformance in this LinkedIn post.
Japanese Yen Bears are Retreating
The Japanese yen has seen sharp gains across the board since the July 11 US inflation report. The yen is up over 4% against the US dollar, with Fed easing bets coinciding with expectations that the Bank of Japan may hike rates further at the July meeting. This potential shift in yield differentials favors the yen.
Meanwhile, Japanese authorities also seemingly intervened in the FX markets after the US inflation report to help strengthen the yen. The move is also potentially squeezing the yen short positions, given yen-funded carry trading has been a popular strategy over the last few years.
Solid Demand at 2-Year Treasury Auction
The latest 2-year Treasury auction witnessed solid demand, indicating strong investor interest in shorter-term government debt. This surge in demand is likely driven by expectations of lower future interest rates, as investors rush in to lock in the current yields.
Investors secured a combined 91% of the auction, the highest since 2003, while primary dealers received a record low of 9%. The 2s10s curve inversion eased to about -24 basis points, nearing the least-inverted levels of the year. The high demand for Treasuries underscores the market’s anticipation of the Fed’s supportive monetary policies continuing.
A Word of Caution
We have been here before.
In late 2023 as well, small-cap index Russell 2000 rose 27% from its October lows, outpacing the 17% gains in S&P 500 and 20% in NASDAQ 100 as markets anticipated Fed rate cuts. However, as Fed rate cut expectations eased, Russell got locked in a range while the large-caps continued to gain on the back of a solid earnings momentum.
