Small caps have lacked relative strength improvement throughout the year against international equity representatives
Small caps have long carried a reputation as the market’s most rate-sensitive corner, and for good reasons. Higher borrowing costs hit smaller companies hardest, given their reliance on floating-rate debt and outside financing. That relationship held up as recently as last year, as the 12% decline in the US Treasury 10 Year Yield Index (TNX) from May through November coincided with the iShares Russell 2000 ETF (IWM) climbing over 20% (5/21/2025 – 11/30/2025). However, that inverse correlation has pivoted sharply in recent months. Since the end of last November through the end of August, both TNX and IWM are up 18%.
The small-cap rate sensitivity has not always been consistent. From 1979 to 2000, the correlation between the Russell 2000 and the 10-year Treasury yield was strongly negative, as elevated rates during that period weighed directly on smaller, more indebted companies. That relationship flipped positive from 2000 to 2019, when declining rates coincided with a slower-growth backdrop, and higher yields tended to reflect stronger economic conditions instead of tighter financial conditions. The negative correlation came back during the 2022-2024 hiking cycle, and we saw the consequences firsthand under the old playbook
What Rate Charts Say Now
If we were simply extending the old playbook forward, the current setup should be a clear headwind for IWM. The default chart for TNX has been trending higher and now sits near multi-year highs, a textbook signal of tightening conditions. The 2-year yield (US2YR) has also moved higher on its chart, outpacing the improvement in TNX. That divergence has pulled the 2s10s spread (USYC2Y10) lower in the back half of August after the spread was unable to surpass levels seen in April and May. This action is near-term in nature, as we still have the 2-point chart trading in a positive trend with a series of higher lows. We are also nowhere near the inverted regime seen after 2022. However, we would like to see more consistency from the 2s – 10s spread, as a flattening curve has historically been an unfavorable setup for small caps.
What IWM’s Chart Says Now
IWM currently holds a fund score above 4.0, making small caps a generally favorable area. The ETF sits in a positive trend, completed two consecutive buy signals, and reached new all-time highs last month. The last few weeks saw a sharp pullback, as IWM declined by over 3% from August 14th through the end of the month. Currently, this seems to be simple consolidation after rapid improvement, as the default chart sits just below the middle of its trading band and has just reversed down into a column of Os on Tuesday (9/1).
The last few weeks of action have seen IWM decline while rates continue to rise, seeing the old playbook re-enter the conversation. On the other hand, IWM was due for consolidation after rising 20% from April 7th through August 13th, so a 3% pullback is not a major concern. While small caps might not play a major role in your portfolio right now, their direction moving forward could have some major implications for relative strength rankings.
Our DALI rankings just saw international equities move back ahead of domestic equities on the last day of August. Those two asset classes are still very close together, which might come as a surprise given the recent rebound for growth-oriented stocks in the US. However, delving underneath the hood of each asset class shows a different story. International equities have seen different areas demonstrate strength at different times throughout the year. Emerging markets rocketed higher in Q1, then developed markets showed some consistency as some other areas corrected in Q2. The last several weeks have seen emerging markets rebound alongside other growth areas globally. Meanwhile, US equities have not enjoyed the same give and take. IWM still sits on an RS sell signal against most broad international representatives like the iShares MSCI Emerging Markets ETF (EEM). Until we see some RS relationships move in favor of small caps, it will likely be difficult to get more follow through on domestic equities improvement in our DALI rankings.
