Do Lower Rates Suggest Small Cap Stocks are in Favor?

Tariff Tantrum: Inflation Fears Appear Overblown Thus Far

The story of 2025 thus far is President Trump’s ‘Liberation Day’ tariffs. Initially, the major US indices, like the Nasdaq Composite, swooned more than 10% in two weeks after the April 2^nd tariff announcement. While the announcement was known to most on Wall Street, the magnitude of the tariffs was far more than most investors anticipated. However, instead of implementing the full-blown, sky-high tariffs, President Trump and his trade negotiators instead chose a “shock and bore” approach, leveraging the US’s massive market to garner favorable trade deals while still leaving a base tariff rate of at least 10% on most countries to bring in much-needed government revenue.

The fear from politicians on both sides of the aisle, famous investors, retail, and Fed Chair Jerome Powell was that the tariffs would lead to rampant inflation. Thus far, the data suggests this has not been the case. While inflation came in slightly ahead of expectations last report, this time, it beat expectations ,leading to yet another rip-roaring rally on Wall Street today, with nearly 80% of stocks rising for the session as volume picked up.

Small Caps React Positively to CPI

Tuesday, theiShares Russell 2000 Index ETF (IWM) bolted ~3% as volume increased 25% versus the 50-day average. Following the day’s bullish inflation report, Polymarket, the world’s largest betting website, attributes an 81% chance that Fed Chair Jerome Powell will finally cut interest rates by 25 Bps on September 17^th.

Interest Rate Cuts are Bullish for Small Caps

Because small caps are more reliant on debt than mega-cap stocks, rate cuts are bullish for small cap companies as these companies pay reduced interest expenses on debt. Additionally, rate cuts tend to bolster the domestic economy, on which most small cap stocks rely on for business.

Small Cap Rotation

With elevated interest rates, small caps have been in the proverbial “dog house with investors.” However, with Nasdaq valuations stretching ever higher and the Russell reasonably valued, rotation is likely to occur as red-hot tech stocks take a break.

Small Caps: A Generational Breakout?

IWM has had several false breakouts, but Tuesday’s breakout feels different for a few reasons. IWM is above its key moving averages for a change, has the rate environment wind at its back, and saw volume increase 24% above the 50-day norm today – a sign of demand.

Crypto Benefits from Lower Rates as Well

In addition to small caps, crypto assets tend to perform well in rate cut environments. Even before any cuts have been announced crypto ETFs are acting well, including the iShares Ethereum ETF (ETHA), the iShares Bitcoin ETF (IBIT), and the Teucrum 2x Long XRP ETF (XXRP).

Bottom Line

The current market environment, characterized by easing inflation fears and a potential shift in Federal Reserve policy toward lower interest rates, is a favorable backdrop for small-cap stocks.

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This article originally published on Zacks Investment Research (zacks.com).

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