A month ago, I wrote that the Federal Reserve was likely to shift from an easing bias to a tightening bias at the June 17 meeting.
That wasn’t the conventional view at the time. The market was still giving the idea of a rate hike relatively low odds, and many investors were more focused on when the Fed might return to cutting.
But I had a different take that I shared with Cabot Wealth Daily readers in this article.
Why? The April FOMC minutes suggested the committee was growing more concerned about inflation risk, especially with oil prices elevated, geopolitical tension running high, and economic data remaining firm.
I also argued that small-cap stocks – despite their historical sensitivity to interest rates – might not flinch much if the Fed started preparing investors for higher rates.
Now we have a pretty good real-time test of that thesis.
At the June 17 FOMC meeting, the Fed did exactly what I expected. It shifted in a more hawkish direction and made clear that officials are no longer leaning toward rate cuts. The latest Summary of Economic Projections (SEP) and Dot Plot showed an upward revision in expected rates, confirming the move from an easing bias to a tightening bias.
To be clear, this does not look like the start of an aggressive tightening cycle.
Rather, the median forecast for the fed funds rate at the end of 2026 rose to 3.8%, only modestly above the current target range of 3.5% to 3.75%. In other words, the Fed is signaling higher for longer, plus a willingness to hike if inflation pressures persist.
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Still, the market has gotten the message.
Back on May 26, the CME FedWatch tool showed a 53% probability of at least one rate hike by year-end. As of today, that combined probability has jumped to 85%.
That is a big shift in less than a month.
But the more interesting part is not just that rate expectations have moved higher. It’s how the market has reacted.
Small caps have not cracked. In fact, they’ve held up better than the major large-cap benchmarks.
As of midday yesterday, the S&P 600 SmallCap Index was trading just 1.2% below its all-time high, which it hit on June 15. By comparison, the S&P 500 was 3.1% below its June 2 high, while the Nasdaq was 4.0% below its June 3 high.
That alone is notable. Small caps are not just hanging around. They are closer to fresh highs than either the S&P 500 or Nasdaq.
The performance since my May 26 article is even more interesting. The S&P 600 is up 3.3% since then, outperforming both the Nasdaq and S&P 500 by roughly five percentage points. Both of those larger-cap indexes are negative over the same stretch.
And since the close on June 17, the day the Fed confirmed its hawkish shift, the S&P 600 is up 1.9%. The Nasdaq is down 0.5%, and the S&P 500 is down 0.3%.
That is not what many investors would expect from a group of stocks that is supposed to be especially vulnerable to higher rates.
Why Are Small-Cap Stocks Ignoring a More Hawkish Fed?
I think the answer is that investors are looking past the potential rate impact and focusing on fundamentals.
Small caps tend to be more sensitive to rates because many smaller companies rely more heavily on floating-rate debt. That makes borrowing costs important. But rates are not the only thing that matters.
Earnings matter. Revenue growth matters. Valuation matters. Market leadership matters.
And right now, small caps continue to look compelling on all fronts.
S&P 600 earnings are expected to rise by 21% this year. The economy has been more resilient than many expected. The AI build-out is supporting broad capital spending and productivity trends. Valuations in the S&P 600, which carries a forward PE of just 16.0, remain far more reasonable than in the S&P 500, which carries a forward PE of 20.3.
That combination appears to be giving investors enough confidence to look through the risk of one or two additional rate hikes and still see relative value in small-cap stocks.
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