Powell Put at Play: Rotation, Yen and Treasuries

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.

Likewise, the Japanese yen gained about 8% against the US dollar in late 2023 on the back of Fed easing expectations, before reversing back to record lows.

This is clear evidence that early optimism on rate cuts is at play here. However, sustained trends are only likely if fundamentals support and the rate cut cycle continues.

However, structural inflation pressures suggest that inflation may not return to the Fed’s 2% target. Factors such as labor supply shortages, supply chain disruptions, the green transition, and sustained fiscal spending will continue to drive inflation. Additionally, US election risks imply that while the Fed may start its easing cycle, but it will likely proceed cautiously with rate cuts to allow time to assess the new administration’s policies and their impact on inflation.

As such, rate cuts from the Fed are unlikely to be enough to resolve profitability issues for the small-cap companies or make the yield differentials unattractive for yen-funded carry trading.