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Small caps shake off the Fed, shake up the market…again

By: Mat Lystra, Senior Research Analyst

I wrote a research note in early 2015 exploring the performance of the Russell 2000® Index during hawkish periods at the Fed.[1] Since we’ve now got a year’s worth of data following the outset of this latest rate-rising cycle, I thought I’d take a look at how things played out this time around. It turns out that history yet again repeated itself.

At the time of my 2015 research, the followers of the Fed were feverishly trying to predict just when interest rates would begin to normalize and how the markets might respond. There were two key takeaways from that research: 1) contrary to worries from market observers, rising interest rates did not necessarily correspond with a fall in value for small caps, and 2) the volatility regime often changed around the time interests rates moved.

The prognosticators got their answer in December 2015, when the Fed’s Open Market Committee (FOMC) voted in favor of raising the Federal Funds Rate (FFR) by 0.25%. My 2015 piece looked at how US small caps, as measured by the Russell 2000 Index, responded to the initiation of a policy tightening cycle after one week, one month, six months and a year.

The table below shows how the Russell 2000 Index measuring US small cap stocks responded to periods of increasing interest rates. Index returns in each of the last four cycles have been negative after one month, but in the most recent three cycles, index returns were up by double-digits after one year. The 2015 cycle had the largest trough-to-peak swing, down -12.3% after one month, but up 22% after 12 months – a remarkable 34.3 percentage point turnaround.

Market volatility, while still moderate, has also clearly begun to tick upwards since predictions of a rate hike gained steam in 2014. The next chart shows the rolling 24-month standard deviation of the Russell 2000 Index (orange line) and the Russell 1000® Index (blue line), as well as periods of tightening by the Fed. Both indexes are still climbing towards their long-term averages; whether they exceed them is anyone’s guess. Inflation and employment are the Fed’s two primary policy-making indicators, but the FOMC’s notes suggest market stability is also monitored continuously.

So it seems in this most recent case, my findings from 2015 were confirmed: Rising interest rates don’t necessarily lead to a decrease in small cap performance, as reflected by the Russell 2000 Index. But it’s nonetheless important to note that volatility may change direction, which may warrant caution.

This period is the only one of the four rate cycles observed where the Fed waited a full year between its first and second rate increases. The Fed may not be so quiet in 2017, and any activity is likely to have an effect on small caps.

For further information, please read our report The Russell 2000 Index in a rising interest rate environment - Evidence from past cycle.


[1] Lystra, M. (2015). The Russell 2000 Index in a rising interest rate environment: evidence from past cycles. FTSE Russell Research, available upon request.

[2] The 24-month rolling standard deviation series have been centered on their midpoints across the time series to better align the timing of interest rate hikes with their impact to volatility.


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