Rising Treasury Yields Pressure Stock Market's Previous High-Flyers

The Russell 2000 index of small-cap stocks closed at 2,793.20 on Wednesday, Oct. 7, down 9% from its record close set less than two months earlier. A correction, generally defined as a decline of at least 10% from a recent peak, would require a close at 2,761.58 or lower. The index fell 1.3% on Wednesday alone, while the S&P 500 and the Nasdaq Composite each slipped 0.2% and the Dow Jones Industrial Average lost 0.7%, according to FactSet.

The main pressure is rising long-term Treasury yields. Their effect has been hidden at the index level because a small group of large technology stocks has kept the S&P 500 near records.

Small caps lose their lead

Until a few weeks ago, small caps were ahead of the S&P 500 for the year, in what was expected to be a year when healthy economic growth would spread gains beyond the largest companies. That lead has now reversed. The Russell 2000 is up 12.5% this year, against 14% for the S&P 500, according to FactSet. The S&P 500 set a fresh record earlier in the week as investors moved back into a narrow group of AI-driven technology stocks.

"The first, and most important factor" behind the decline in small caps has been the rise in long-term Treasury yields, said Keith Lerner, chief investment officer at Truist Advisory Services. "The higher interest rates are biting — it's just that the technology sector has masked that."

Why rates hit small companies harder

The difference comes down to how companies borrow. "Small caps are more interest-rate sensitive, they have more debt and more floating-rate debt than their large-cap counterparts," Lerner said. Smaller companies, many of them unprofitable, rely heavily on variable-rate debt to fund growth. When rates rise, their interest costs rise with them and eat into already thin margins. Higher yields also raise refinancing costs and weigh on valuations.

Yields have been pushed up by inflation concerns, higher oil prices and a growing federal deficit. The largest companies, including the "Magnificent Seven" tech stocks, have been nearly insensitive to that rise in recent months, even though they have borrowed heavily to fund the AI build-out. Investors have turned to them, and to other companies reporting strong earnings, as a relatively safe place during volatile moves in rates.

Small caps also have less exposure to technology, which has driven the S&P 500's gains. Even small technology companies have not been spared: the Invesco S&P SmallCap Information Technology ETF (PSCT) has fallen 10.4% from its record high on June 30, according to FactSet.

The damage beyond small caps

Rate-sensitive sectors within the S&P 500 have also fallen since early September, according to FactSet:

• Financials: down more than 7%
• Real estate: down more than 7%
• Materials: down 5.4%
• Industrials: down 4%

Steve Sosnick, chief strategist at Interactive Brokers, described the economy as "good," but said growth has become dominated by the construction of AI data centers. "The second-quarter GDP of 2.2% is not necessarily going to lift all the boats," he said. "So, you have this uneven economic growth, and with interest rates backing up substantially, that's a tough environment for small caps."

What the Fed signals and what to watch

The Federal Reserve has signaled more tightening. It raised its benchmark rate in September to a range of 3.75% to 4%. Minutes of that meeting, released on Oct. 7, showed that most officials judged another quarter-point increase would likely be appropriate before the end of the year.

Points to follow:

• Whether the Russell 2000 closes at or below 2,761.58, the level that would mark a correction.
• Long-term Treasury yields, which Lerner identified as the main driver of the decline.
• The Fed's next decisions, after most officials signaled one more hike this year.
• Third-quarter earnings from rate-sensitive sectors, especially financials and real estate.