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The Fed basically confirmed what everyone assumed, that while the economy is slowly recovering, the Central Bank still believes the anemic state of the US economy requires the drip feed of easy money. To that end, the Fed is maintaining its effective policy of near zero interest rates and will also continue its asset purchase program, i.e. QE2.

But if the Fed’s statement lacked drama, it may nonetheless surprise investors that they may be overlooking the beneficiary of the low interest rate environment: small cap stocks.

Many investors have focused on the impact of quantitative easing on the dollar, and by extension US exporters. The reasoning goes that further asset purchases by the Fed will continue to put pressure on the dollar, supporting large cap firms with significant international exposure.

There may be some truth to that. But historically the biggest beneficiary of ultra-loose monetary policy has actually been small cap stocks.

In environments characterized by negative real interest rates US small caps tend to outperform US large caps. The reason is that negative real rates have historically favored riskier assets, including US small cap stocks.

According to Bloomberg, Fed Funds futures markets imply a 70% probability that short term interest rates will not rise through the end ofQ2. In fact, real short-term interest rates – the Fed Funds minus inflation – have been negative for the past year and are likely to remain negative for at least the first part of 2011 (see Chart 1).

graphs_Real-Fed-Funds-Rate

At the same time that the Fed is keeping rates low, they are also determined to drive inflation expectations higher through an extension of their quantitative easing. Expected inflation levels derived from TIPS prices suggest that investors have raised their expectations for US inflation. As recently as August, TIPS prices were suggesting an expected inflation rate of approximately 1.5% over the next decade. As of the end of November the breakeven inflation rate had risen to 2.15%. The combination of short term rates anchored at zero with rising inflation expectations equates to an even more accommodative monetary stance.

And as investors raise their inflation expectations; this drives real short term rates deeper into negative territory.  Historically, there have been several periods characterized by negative real interest rates: 1979-1980, late 1992 to early 1993, 2003 to mid-2005, 2008, and late 2009 to present. With the exception of a brief period in the early 1990’s, these instances have coincided with periods of small cap outperformance.

Since 1979, the Russell 2000 has outperformed the S&P 500 by roughly 14 bps a month, on average. However, most of this outperformance has been concentrated within those periods when real interest rates were negative. In months when the real Fed Funds rate was negative, small caps beat large caps by an average of 92 bps a month. In contrast, during the majority of the time when real short term rates are positive, small caps nominally underperform US large caps.

Bottom line, while a weak dollar will support the larger multi-nationals, the Fed’s willingness to keep interest rates anchored near zero may offer even a bigger boost to their smaller brethren.

 

All data from Bloomberg 11/10:

Investments in smaller companies typically exhibit higher volatility.  Past performance does not guarantee future results.