March is starting out differently than February, but it's still playing a familiar market theme: small-caps are again outperforming large-caps, contradicting the wide consensus of expectations from market strategists.

During February, large-caps in the Dow Jones Industrial Average and the S&P 100 index did outperform their small-cap peers, as represented by the Russell 2000 index. The Dow rose 1.2% and the S&P 100 rose 0.3%, while the Russell fell 0.4%.

But the wide array of market strategists calling for a return of large-cap outperformance, after years of small-cap outperformance, haven't yet won. Sure, the S&P 100 was up 1.8% and the Dow up 2.6% year to date through the end of February. And much fanfare has accompanied the Dow passing, and staying above, the key 11,000 level.

But that all pales in comparison with the Russell's 8.5% gain through Feb.28. After February's underperformance, the index was again faring better than large-caps so far this week. The Russell was up 0.5% through Thursday's close, compared with a 0.3% drop for the Dow and a 0.04% gain for the S&P 100.

That was even after the Russell's 0.3% drop on Thursday, which was a slightly bigger drop than for the other indices. The S&P 100 fell 0.2%.

On Thursday, the Dow fell 28.02 points, or 0.25%, to 11,025.51. The S&P 500 fell 0.16% to 1289 and the Nasdaq Composite dropped 0.15% to 2311. Google ( GOOG ) bucked the trend after its CEO reassured Wall Street about the firm's prospects.

Disappointing retail-sales numbers for February and rising crude oil prices were behind the weakness seen Thursday. Specialty retailers Chico's FAS ( CHS), Abercrombie & Fitch ( ANF), Gap ( GPS) and New York & Co. ( NWY) were among the victims of a northeast blizzard (or changing fashion trends) that cut sales last month.

To a large extent, the debate over small-caps vs. large-caps is one about the outlook for the U.S. economy. Those predicting that large-caps will outperform this year believe these stocks are cheap relative to smaller names and offer protection to investors if the economy slows.

Small-caps, whose earnings tend to grow faster than large-caps, benefited from the low interest rate environment of the past few years, which has encouraged risk-taking. Low interest rates tend to benefit smaller companies, which rely more on leverage than their equity to expand.

Of course, the low interest rate environment is already in the process of unraveling.

U.S. Treasury bonds fell sharply on Thursday after the European Central Bank lifted its key interest rate to 2.50%. While the move was widely expected, the ECB signaled there might be more to come, saying it feels its monetary policy remains accommodative to growth. The benchmark 10-year Treasury bond fell 12/32 in price while its yield, which moves inversely, rose to 4.64%, a four-month high.

The prospect of rising bond yields in Europe heightens the global competition with U.S. Treasuries. The ECB move comes on the heels of the Bank of Japan signaling over the weekend that it will likely soon start unwinding its 5-year-old zero-rate policy.

"The ECB move reinforced the view that central banks are in the process of removing global liquidity," says Michael Gregory, interest rate strategist at BMO Nesbitt Burns.

Central banks in the U.S., Japan and Europe had brought interest rates to historically low levels over the past few years, injecting liquidity in the financial system to boost global growth.

Now that signs of growth -- and inflationary pressures -- are showing up in Japan and in Europe, the BOJ and the ECB are joining the Federal Reserve in mopping up some of that liquidity.

The Fed is widely expected to again hike rates on March 28, which would take its key rate to 4.75%. It is also increasingly expected to hike the rate to 5% in May, amid continued signs of growth in the economy.

On Thursday, news that jobless claims rose more than expected in the latest week did little to allay the Fed's concerns over a tightening job market. Claims have remained below 300,000 for six consecutive weeks, compared with their average of 332,000 a week in 2005, according to Bloomberg.

Such signs of continued economic growth should continue to benefit small-caps, even if the Fed continues to raise interest rates.

According to Henry McVey, market strategist at Morgan Stanley, that's the bet that many hedge funds continue to make. Small-caps are also seen as benefiting more from strong earnings growth and smaller-than-normal risk premiums for corporate bonds, which "might keep small-caps rallying for much longer" than currently expected, McVey wrote in a research note.

There are growing risks, however, as central banks continue to remove global liquidity. The so-called yen carry trade, in which speculators borrow yen at zero interest to invest in everything from U.S. and emerging-market bonds to commodities, is likely to unwind now that the BOJ seems poised to lift rates.

The BOJ had pledged to keep its easy monetary policy until core prices stopped falling for at least a few months. On Friday, Japan's consumer price index is expected to show core inflation rising at 0.4% in February, marking the third consecutive monthly increase.

According to Michael Metz, market strategist at Oppenheim & Co, hundreds of billions of dollars of hedge fund money have been involved in the carry trade, and most of these investments are leveraged. That means if these bets start turning the wrong way borrowers have to rush in to sell their investments to respect their minimum margin requirements.

A sell-off in the Icelandic krona last week was the perfect example. The krona plunged 9% as carry traders who had borrowed at the lower euro rates to invest in Iceland's 10% interest rates were caught by surprise by a Fitch downgrade of the country's debt.

Should hedge fund money be caught wrong footed elsewhere, small-cap stocks wouldn't necessarily be the best place to be.
In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback; click here to send him an email.