2025 Small-Cap Stock Rally Faces 2026 Headwinds from Rising Treasury Yields

This analysis is based on the MarketWatch article [1] published on December 9, 2025, which highlights that the record rally in U.S. small-cap stocks faces a potential 2026 headwind: rising Treasury yields.

• Short-Term Performance (2025):
  The Russell 2000 Index (^RUT), a benchmark for small-cap stocks, has rallied 12.45% YTD through December 8, 2025, driven by a low-interest-rate regime (Fed rate cuts: 1% in 2024, 0.5% in 2025) [0].
• Long-Term Risk (2026):
  JPMorgan strategists forecast 10-year Treasury yields to rise to 4.35% by end-2026 (from ~4.08% in 2025) as market expectations for further Fed rate cuts fade [2]. Small-cap companies, which are more reliant on debt financing than large-caps, face higher borrowing costs if yields increase, potentially slowing growth.
• Fundamental Improvements:
  Individual small-cap firms like Univest Financial have shown strong fundamental momentum, with Q3 2025 net income increasing 37.9% YoY to $25.64M [4].

1. Interest Rate Sensitivity:
   Small-cap stocks’ higher debt-to-equity ratios and shorter-term debt maturities make them more vulnerable to rising yields compared to large-caps [2]. This sensitivity could reverse the 2025 rally’s tailwinds if yields increase as projected.
2. Mixed Outlook Dynamics:
   The contrast between improving current fundamentals (e.g., Univest’s earnings growth [4]) and future yield risks creates a nuanced outlook, requiring careful monitoring of both factors.
3. Sentiment Dependence:
   The rally’s sustainability hinges on market expectations for Fed rate cuts. A shift in Fed communication that reduces these expectations could trigger a sentiment-driven sell-off in small-caps [3].

• Risks:
  • Rising borrowing costs from higher Treasury yields [2].
  • Fading market expectations for Fed rate cuts in 2026 [3].
  • Uncertainty in sector-specific fundamentals (e.g., earnings growth, profit margins across small-cap sectors) [4].
  • Lack of clarity on the exact trajectory of 2026 Fed rate policy [3].
• Opportunities:
  • Improving earnings momentum (e.g., Univest Financial [4]) could support resilient small-caps despite yield headwinds.
  • Undervalued small-cap stocks may present opportunities for investors focusing on strong fundamentals [4].
• Monitoring Priorities:
  Track 10-year Treasury yields, Fed policy announcements, Q4 2025 and 2026 quarterly earnings reports, and sector-specific fundamental metrics [2][3][4].

• Russell 2000 YTD Return (2025):
  +12.45% [0]
• JPMorgan 10-Year Treasury Yield Forecast (End-2026):
  4.35% [2]
• Univest Financial Q3 2025 Net Income:
  $25.64M (up 37.9% YoY) [4]
• Information Gaps:
  Sector-specific earnings growth, profit margins, and debt levels; Fed 2026 rate policy clarity; yield spreads between small-cap corporate bonds and Treasuries [3][4]
  No prescriptive investment recommendations are provided.