With the Fed expected to cut rates next month, should we buy the recent rise in rate sensitive areas?
The Federal Reserve cut interest rates three times at the end of last year, and despite a solid overall year for stocks, investors have been left hanging with zero interest rate cuts so far in 2025. However, that may soon change, with an 87% implied probably of cuts in September after Fed Chairman Powell signaled the potential for cuts at his Jackson Hole speech last week (Source: CME FedWatch). As a result, some interest rate sensitive areas of the market have popped as investors eagerly hold out for their long-awaited cuts. Given the renewed optimism, should we buy the hype or fade the noise for these groups?
Small cap stocks are among the biggest beneficiaries of falling interest rates due to their higher reliance on borrowing and exposure to more floating-rate debt. After lagging large caps for some time, small caps have recently flipped the script. The Russell 2000 (RUT) up 5% over the last month, outpacing the S&P 500 by 3.5%. The index is now less than 4% away from all-time highs after being 29% away earlier this year. This rebound is reflected in the space’s relative strength. The iShares Russell 2000 ETF (IWM) holds in acceptable fund score of 3.21, in addition to a sharply positive score direction of 2.83, highlighting its significant improvement. That said, large caps still lead in strength, with the SPDR S&P 500 ETF Trust (SPY) scoring two points higher at 5.21.
Homebuilders are highly sensitive to changes in interest rates, as lower rates translate to lower mortgage costs and increased housing demand. After underperforming through April, the group has staged a strong rally, with the iShares U.S. Home Construction ETF (ITB) rising 10.3% over the last month. ITB now holds an acceptable fund score 3.49, which is up 2.43 points from its low in mid-June. Although, homebuilders have been dragged down by the larger names in sector such as Lennar (LEN). The equally weighted SPDR S&P Homebuilders ETF (XHB) holds a stronger fund score of 4.90 after completing six consecutive buy signals, making it a stronger fund to look towards.
Interestingly, the bond market has yet to see the same level of bounce as rate sensitive equities. Specifically, the iShares US Core Bond ETF (AGG) has risen a modest 1% over the last month. This lack of improvement is also reflected in the relative strength of the fund, with it holding a weak fund score of 1.66 despite moving to a positive trend in July. Meanwhile, the fixed income group continues to sit in the last place of DALI. So, despite rate sensitive stocks seeing notable improvement, the same cannot be said for bonds. The group is still far off from returning to acceptable territory, even if it’s been ticking higher recently.
Whether the stock market is getting ahead of themselves on cuts is yet to be determined, but interest rates sensitive stocks are certainly an area to keep an eye on given their improvement, especially if the promised rate cuts finally come to fruition. Meanwhile, bonds continue to be laggards, suggesting that optimism is still concentrated in equities for now. Overall, investors should monitor both groups for signs of improvement in the coming months once rates (hopefully) move lower.
