Small-cap stocks eye rally as Fed set to cut rates after 10-month pause

Small-cap stocks are lining up for a big rally as the Fed prepares to cut rates this week. After nearly a year of sitting still, the U.S. central bank is expected to lower its federal funds rate by 25 basis points at the end of its September meeting.

According to CME’s FedWatch Tool, there’s a 96% chance of a quarter-point cut and only a 4% chance of a 50bps cut.

This is the first rate cut after a 10-month pause since December 2024. That matters. When the Fed cuts after long breaks like this, small-cap returns have historically outperformed.

Michael Graham, analyst at Canaccord Genuity, said this setup has only happened four times since 1980 (excluding June 1989), and every time the Russell 2000 outpaced the S&P 500. Average returns were 35% for small caps versus 23% for large caps in the following 12 months.

Small caps benefit more when the Fed cuts after a long pause

Graham noted the unique nature of this cycle. “One somewhat unique characteristic of this easing cycle has been the elongated nature, with a long pause since the last rate cut in December 2024,” he said. “Returns following rate cuts that have come after a pause of at least 126 trading days are encouraging.”

Small companies tend to carry more debt and rely more on bank loans. So when the Fed makes borrowing cheaper, they feel the relief faster. Canaccord’s report earlier this month pointed out that easier monetary policy boosts smaller firms more than large ones because of their higher leverage and tighter cash positions.

Tom Lee, head of research at Fundstrat Global Advisors, backed that up. He told CNBC’s Squawk on the Street that the Fed’s approach is bullish for small-cap performance. “I think it means we have a dovish Fed again,” Tom said. “That’s kind of a green light for small caps.”

The Russell 2000, which tracks 2,000 of the smallest stocks in the Russell 3000, has already been showing signs of investor interest, especially through the iShares Russell 2000 ETF (IWM).

Rate cut expected but market split on short-term reaction

Not everyone is convinced this cut is the right call. Ed Yardeni, longtime market watcher, said in a note Tuesday that cutting rates now is like “throwing gasoline on a fire.” He said the action isn’t necessary given that the U.S. economy is still growing and there’s no financial crisis.

“More often than not in the past, monetary easing cycles started when the previous tightening of monetary policy triggered a financial crisis,” Ed wrote. “But the Fed cut the fed funds rate by 100bps at the end of last year even though there was no credit crunch and no recession.”

He warned that continued cuts could push inflation above the Fed’s target and fuel more risky speculation in stocks.

And speculation is definitely in play. The S&P 500 is already up 12.3% in 2025. High-flyers like Paramount Skydance and Palantir Technologies have surged 67% and 125% year-to-date. Historical trends also show the stock market tends to rally when the Fed cuts while the S&P 500 is within 1% of its record high. But that rally might not last.

Some analysts expect a “sell the news” reaction. Adam Crisafulli of Vital Knowledge said Wednesday might bring a short-term drop. “Many feel there will be a ‘sell the news’ response to this outcome since the narrative has already swung aggressively toward the dovish end of the spectrum,” Adam wrote.

JPMorgan’s trading desk thinks the same, as it warned that investors could pull back as they weigh several moving parts, like the broader macro outlook, future Fed policy decisions, thin corporate buybacks, weaker retail trader activity, and quarter-end portfolio reshuffling.

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