Are Odds Improving for a Fed Rate Cut? ETFs to Consider

February has proven more volatile than January for investors. AI-driven disruption fears in February have triggered a sharper risk-off shift, with investors seemingly adopting a “sell first, ask questions later” approach.

However, Friday’s U.S. Consumer Price Index (CPI) release offered some relief, easing inflation concerns and reinforcing expectations that the Federal Reserve could begin cutting rates around mid-year.

According to CNBC, consumer inflation rose 2.4% year over year in January, down from 2.7% in December, returning to its April 2025 level. Core CPI increased 2.5% annually, marking its lowest reading since April 2021. Economists had expected both headline and core inflation to come in at 2.5%.

Fed Easing Odds on the Rise

Per Phil Blancato, Osaic chief market strategist, as quoted on the above-mentioned CNBC article, recent inflation readings are likely to be well-received by markets, especially as expectations build around the nomination of Kevin Warsh as Fed Chair. If this trend persists, it could help pave the way for lower interest rates while keeping inflation in check.

According to Reuters, following softer-than-expected January inflation data, U.S. interest rate futures boosted expectations for a June rate cut. Federal funds futures now imply roughly a 70% probability that the Fed will resume easing at its June meeting compared with 64% before the report.

According to the CME FedWatch tool, markets are anticipating a 50.7% likelihood of interest rates being lowered to 3.25-3.5% in its June 2026 meeting, up from a 44.5% likelihood just a month earlier. Expectations strengthen further for July. The FedWatch tool shows an 80.4% likelihood of a rate cut by July, including a 29.8% probability that rates will fall to 3-3.25% compared with 22.2% just a month ago.

ETFs to Explore

Below, we highlight ETFs that investors may consider if the Fed begins cutting rates in June.

Small-Cap ETFs

Being heavily dependent on external borrowings, small-cap stocks could massively benefit from lower interest rates, which could increase their capital availability. Reduced rates also allow these companies to refinance existing debt at a cheaper rate, enabling them to invest in growth and expansion. The S&P SmallCap 600 has gained 8.81% this year so far and 3.09% in February till now.

Investors can consider iShares Core S&P Small-Cap ETF IJR, iShares Russell 2000 ETF IWM and Vanguard Small Cap ETF VB.

All the mentioned funds have a Zacks ETF Rank #2 (Buy), with VB being the cheapest option, charging an annual fee of 0.03%. IJR is the best-performing fund among the above-mentioned ones, gaining 8.31% over the past three months and 5.60% over the past month.

Financial ETFs

The anticipated Fed interest rate cuts in 2026 should provide a meaningful tailwind for the sector, as this could lower capital costs for banks. Within the financial sector, banks with diversified operations could see stronger loan activity as rates decline.

Despite coming under pressure earlier last week amid rising concerns about AI-driven disruption, the outlook for the financial sector remains constructive. The recent weakness appears largely sentiment-driven rather than rooted in fundamentals, potentially offering a buy-the-dip opportunity for long-term investors (Read: AI Fears Weigh on Financial Stocks: What's Ahead for Financial ETFs?).

Below, we highlight a few funds for investors to consider their exposure to the U.S. financial sector. Investors can consider State Street Financial Select Sector SPDR ETF XLF, Vanguard Financials ETF VFH and iShares U.S. Financials ETF IYF.

XLF and VFH have a Zacks ETF Rank #1 (Strong Buy), and IYF has a Zacks ETF Rank #2. Regarding charging annual fees, XLF is the cheapest option, charging 0.08%.

Utility ETFs

The utilities sector, being capital-intensive, also benefits from reduced financing costs when interest rates fall. Additionally, as a low-beta sector, utilities are relatively shielded from market volatility, making them a defensive investment and a safe haven during economic turmoil.

Investors should gain from funds like Utilities Select Sector SPDR Fund XLU, Vanguard Utilities ETF VPU and iShares U.S. Utilities ETF IDU.

All the mentioned funds have Zacks ETF Rank #2 (Buy), with XLU, VPU and IDU having dividend yields of 2.49%, 2.51% and 2.05%, respectively. Among the three mentioned funds, VPU has performed better over the past year and the past month, gaining 14.96% and 1.61%, respectively.

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

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