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Small-cap stocks are set up for a decline.
That’s an unpopular opinion, for sure. After all, the small caps have been big winners so far in 2026. The iShares Russell 200 ETF (IWM) is up 18% since the start of the year – easily outpacing the 9% gain in the S&P 500.
But, small cap stocks are likely to come under selling pressure in the coming weeks as investors price in the increasing probability of higher interest rates.
Let me explain…
Rising short-term interest rates are bearish for stocks in general. They are especially bearish for small-cap stocks.
Small caps typically carry more floating-rate debt relative to their size, and they have less access to capital markets than large caps. When rates rise, their borrowing costs jump immediately, squeezing margins. Small-cap companies also can’t issue investment-grade bonds as easily, so refinancing becomes expensive or impossible — forcing reliance on bank loans at elevated rates.
This isn’t a concern when interest rates are falling or are stable – which was the case for all of 2026, until Wednesday.
Now though, the FOMC appears to be turning hawkish. Nine of the 18 voting members of the FOMC now project an interest rate hike before the end of 2026. Six members expect two rate hikes by year-end.
That’s a BIG change from the easy-money policy the FOMC has held up to this point.
As short-term interest rates go up, small cap stock prices are likely to come down.
The technical setup in IWM shows the potential for this to happen. Take a look at this chart…
For the past several weeks, IWM has been making a series of higher highs and higher lows. That is a bullish trend. There’s nothing at all wrong about the price action.
But, the momentum indicators at the bottom of the chart are telling a different story. As IWM has been pressing higher, the momentum indicators have been moving lower. This sort of “negative divergence” tells us the momentum behind the small-cap rally is fading. It’s an early warning sign of a potential change in trend.
It’s possible we may have seen an intermediate-term high for the small cap sector.
The Fed is shifting from an easy-money policy to a tight-money policy. Short-term interest rates are likely headed higher over the next few months. As a result, small-cap stocks are likely headed lower.
Best regards and good trading,
Jeff Clark
Editor, Market Minute