Fed December Rate Cut Expectations: Impact on Small Caps and Financials

This analysis is based on the Seeking Alpha article [1] published on December 5, 2025, which reports that markets anticipate a Federal Reserve (Fed) rate cut, with CME FedWatch showing an 87.2% probability of a 25 bps reduction at the upcoming December meeting. Internal market data [0] reveals that small caps (IWM) and the financial sector (XLF) outperformed broader indices between November 5 and December 5, 2025: IWM gained 3.76%, XLF 2.51%, compared to the S&P 500 (+1.53%), NASDAQ (+0.88%), and Dow Jones Industrial Average (+1.95%). This outperformance aligns with market expectations for looser monetary conditions—small caps are disproportionately affected by interest rates due to their higher relative borrowing costs, while financials benefit from improved net interest margins and increased lending activity when rates decline.

The pre-meeting outperformance of IWM and XLF suggests that market participants have already priced in the expected 25 bps rate cut to a significant extent. The post-meeting market reaction will likely be driven by two critical factors: the Fed’s actual monetary policy decision and Chairman Jerome Powell’s post-meeting comments regarding the future trajectory of rate cuts. If the Fed’s actions and guidance align with current expectations, it could support sustained performance in small caps and financials. Conversely, any deviation (e.g., no rate cut, hawkish forward guidance) may trigger market volatility, especially affecting these rate-sensitive segments.

A primary risk is the potential for overpriced expectations. If the Fed does not cut rates or provides less dovish guidance than anticipated, markets could experience a correction, with IWM and XLF potentially facing more significant downside due to their pre-meeting outperformance. Additionally, the future path of rate cuts remains uncertain, as the Fed will continue to assess inflation trends and economic data. Opportunities may emerge if the Fed follows through with the expected cut and signals a clear path toward further monetary easing, which could boost investor sentiment and support continued gains in rate-sensitive sectors and broader markets.

As of December 5, 2025, the CME FedWatch Tool indicates an 87.2% probability of a 25 bps Fed rate cut in December [1]. Small caps (IWM) and the financial sector (XLF) have outperformed broader market indices over the past month, reflecting expectations of looser monetary conditions [0]. The post-meeting market reaction will depend on the Fed’s decision and forward guidance, with potential volatility if outcomes differ from current market expectations.