Inside Markets — RTY Rally

The Russell 2000 (RTY) is up +6.4% (intraday) since Thursday’s dovish CPI print vs. down 0.4% for the S&P 500 (SPX). Most of the relative underperformance in the SPX came on Thursday when a knee-jerk response to the data resulted in rotation out of mega-cap Tech. Defensive sectors like Utilities, Staples and Health Care are usually the ‘source of funds’ for a cyclical rotation, while secular growth stocks advance but underperform on a relative basis.  In our opinion, the selling of mega-cap Tech on Thursday was due to stretched long positioning in Mag 7 names. Price action today better fits the template of a typical rotation as secular growth stocks advance but lag behind cyclical groups. On Friday, the RTY managed to close just above LT range resistance that we defined as ~2140. In our view, the index needs to sustain levels above ~2140 for 2-3 days to confirm the breakout. The early days (3-5 days) of any rotation are driven by short-covering with very light long positioning in small cap stocks adding fuel for the RTY rally to continue. However, a sustained RTY break above range resistance in the near term requires support from tomorrow’s retail sales number.  Most cyclical rotations follow a recession and start with expectations for large-scale monetary easing. A cyclical rotation from here requires the soft landing narrative (disinflation without a meaningful drop in growth) remains intact.

The earliest calls for imminent rate cuts began almost a year ago with OIS markets reflecting increased probability.  At the time, we pointed to the still-flat 5-10 year yield curve as a reason to be skeptical. The 5-10 curve reached +6bp in early October before falling back into negative (inverted) territory.  In our opinion, an imminent Fed rate cut should be preceded by a change in trend for the 5-10 curve that we identified as ‘sustained levels above +19bp.’  We still see +19bp as the correct 5-10 yield spread that would signal a Fed rate cut 4-6 weeks forward.