M2K: SmallCap May Get a Big Lift with Rate Cuts UnderwayCME: Micro E-Mini Russell 2000 Futures ( GETTEX:M2K )
Global financial market orbits around Federal Reserve’s interest rate decisions. Hiking interest rates means monetary tightening while cutting them signals easing.
In the past three years, we have witnessed a full cycle of Fed hikes and now its reversal.
• In March 2022, as inflation rose rapidly, the Fed started a series of rate increases, pushing the Fed Funds rate up by 525 basis points from 0-0.25% to 5.25-5.50%.
• In September 2023, after 11 consecutive rate hikes, the Fed put the brake on. It kept the Fed Funds unchanged for a full year in eight FOMC meetings.
• Last Wednesday, the Fed finally entered the long-awaited rate cut cycle. It slashed interest rates by a supersized half point, or 50 basis points, in its first cut since 2020.
According to the Bureau of Labor Statistics (BLS), the latest reading of headline CPI is 2.5% in August, down 6.6% from its peak in July 2022. We may conclude that the Fed has largely completed its mission of combating inflation.
The BLS data shows that the U.S. unemployment rate has risen to 4.2% in August 2024 from 3.6% two years ago in August 2022. Fed’s easing signals its pivot to the second mandate, to support full employment. Lowering interest rates could reduce borrowing costs, and in return help business expansion and employment.
Russell 2000: SmallCap may get the biggest Boost
The discounted cash flow (DCF) model estimates the present value of an investment based on its expected future cash flows. A lower cost of capital (CoC) shall cause the price of the investment to go up, other things equal.
Small companies would gain the most compared to larger corporations. In the preceding rate hike cycle, they were hit hard as credit standards got tightened and credit spreads expanded. We will now see the reversal.
Russell 2000 is the benchmark stock market index for US small companies. CME Micro E-mini Russell 2000 futures ( GETTEX:M2K ) were settled at 2,252.6 on Friday, up 10.05% year-to-date.
For a comparison, the S&P 500 gained 19.50% YTD as of Friday, while the Nasdaq 100 was up 17.59%. In my opinion, the major stock indexes rose on the back of the AI-driven technological breakthroughs, where Big Tech dominated but few Small Cap companies could benefit. In this new cycle, lowered borrowing costs and the abundance of credit could help small businesses improve their balance sheets.
The Fed is expected to continue cutting rates in the next two years. Corporate bond yields could likely return to the 2-3% range. The credit spreads, including Baa-Bbb, Baa-Bb, and Baa-Ccc, would likely get smaller. This could bring further boost to the Russell index.
Could we quantify the impact of rate cuts? Let’s illustrate this with a $1 million payment, to be received in five years.
• Applying the BBB corporate bond yield of 4.88% as the CoC, present value of $1 million will be $788,019.
• If the CoC moves down by 250 bps to 2.38%, the PV will be increased to $889,046.
• This shows that a 2.5% reduction in CoC could boost the PV by 12.8%.
The same concept would work on the Russell index. CoC could drop either due to interest rate decrease or because of the narrowing of credit spread, which favors smaller companies. The result would be an increase in the market value of Russell component companies.
For someone with a bullish view of the Russell 2000, he could establish a long position in CME Micro E-mini Russell 2000 futures. The contract has a notional value at $5 times the index. At Friday closing price of 2,252.6, each December contract (M2KZ4) is worth $11,263. CME Group requires an initial margin of $760 for each M2K contract, long or short.
The Fed will next convene on November 5th-6th and meet one last time in 2024 on December 17th-18th. In my opinion, if the Fed continues lowering rates in these two meetings, Russell 2000 could likely move up further.
Hypothetically, if the Russell is 5% higher by December, the 113-point increase would translate into $563 (=2252.6*0.05*$5) gain per contract for the long holder.
The risk of long futures is the index going down. If inflation spikes unexpectedly, the Fed could possibly pause its rate cuts, casting doubt on the future rate trajectory. For more experienced traders, put options on the E-Mini Russell 2000 futures could be deployed to hedge the downside risk.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
