The Possibility of Rate Cuts Poses a Heightened Risk for Small-cap Stocks, Warns Bank of America

Small-cap stocks are encountering heightened risks due to a surge in bond market interest rates, with the Russell 2000 index entering correction territory.

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Market Overview

The Russell 2000 index, a key benchmark for small-cap U.S. equities, recorded a modest gain on Monday but remains 1.6% lower year-to-date, according to FactSet data. On Friday, the index’s sharp decline pushed it into correction territory—a drop of 10% or more from a recent peak.

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Despite the resilient U.S. economy, small caps face increased refinancing risks, according to a note from equity and quantitative strategists at BofA Global Research dated January 12. The strategists highlighted that BofA economists now believe the Federal Reserve’s rate-cutting cycle has ended. This perspective emerged after December’s stronger-than-expected U.S. jobs report and the persistence of inflation above the Fed’s 2% target.

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Impact of Rising Treasury Yields

The robust jobs report has amplified concerns regarding the Russell 2000 index, which appears tightly linked to market expectations for the Fed’s rate path, the BofA strategists noted. Adding to the pressure, the 10-year Treasury yield, which has climbed significantly, has negatively impacted small-cap stocks.

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The strategists highlighted that the performance correlation between small caps and the 10-year Treasury yield is now the "most negative in our data history." Treasury yields continue to rise against the backdrop of an expanding U.S. economy, making refinancing for smaller companies increasingly expensive.

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On Monday, the 10-year Treasury yield rose to 4.802%, its highest level since October 31, 2023, based on 3 p.m. Eastern Time data from Dow Jones Market Data.

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Challenges for Small Caps

Small-cap stocks tend to perform better during periods of economic recovery when interest rates are low. Historically, these stocks have outperformed in the 12 months following the Federal Reserve’s final rate cut and during the interval between the last cut and the next hike. However, unlike previous cycles, the current rate-cutting period has not coincided with a recession, which typically paves the way for small-cap recovery.

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BofA strategists noted that small-cap stocks rallied in mid-2024 amid optimism about the Fed’s cutting cycle. However, the Fed’s hawkish December policy meeting contributed to the Russell 2000’s worst relative performance against large-cap stocks since 1998.

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The current situation is further complicated by the Fed’s apparent pause in its rate-cutting cycle. With inflation remaining stubbornly high and borrowing costs elevated, small-cap companies are struggling to emerge from their profit recession.

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Given the uncertain environment, BofA strategists recommend focusing on economically sensitive small-cap stocks with low refinancing risks. They emphasize prioritizing higher-quality stocks with positive earnings and favorable revisions. Among sectors, financials stand out as the best-performing within both small- and mid-cap categories, according to their analysis.

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Additionally, BofA strategists express a preference for mid-cap stocks over small caps. Mid-cap companies tend to have stronger balance sheets, lower interest rate exposure, and reduced policy risk, making them more attractive in the current economic landscape.

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Small-cap stocks initially saw gains following Donald Trump’s election victory but have struggled recently. The Russell 2000 index ended Monday 2.9% below its closing level on U.S. Election Day, November 5, after closing Friday down 10.4% from its November 25 peak.

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In Monday’s session, the Russell 2000 and the large-cap-focused Russell 1000 index each gained 0.2%. Meanwhile, broader U.S. stock market benchmarks posted mixed results. The S&P 500 rose 0.2%, the Dow Jones Industrial Average gained 0.9%, and the technology-heavy Nasdaq Composite fell 0.4%, according to FactSet data.

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Small-cap equities face a challenging road ahead as they grapple with rising Treasury yields and refinancing risks. While a resilient U.S. economy may provide some support, the combination of high inflation and the Fed’s restrictive monetary stance creates a difficult environment for smaller companies.

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Historically, small caps have rebounded strongly following periods of economic recession and Federal Reserve rate cuts. However, the current cycle’s unique dynamics—characterized by ongoing inflation and no clear recession—could limit their potential upside in the near term.

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Investors are likely to focus on high-quality small-cap stocks within economically sensitive sectors as they navigate the uncertainty. For now, mid-cap equities may offer a safer alternative, given their comparatively robust financial health and reduced sensitivity to interest rate fluctuations.

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