It is usually said that small-cap stocks have more interest sensitive than their large-cap peers because they depend on external financing. That seems plausible. But what does the info say?
My most important findings are:
- The monthly returns of smaller stocks don’t react more to rate of interest changes than the returns of larger stocks.
- On average, small stocks don’t perform worse than large stocks in periods of rate of interest hikes by the Federal Reserve (Fed). Interest rate hike periods are those described by Alan Blinder in a Current paper.
- The relationship between stocks and rates of interest is just not stable. There are phases wherein stocks are very rate of interest sensitive and phases wherein they should not.
- The Federal Reserve Bank of Chicago’s (Chicago Fed) National Financial Conditions Index (NFCI) – an indicator of the final ease of access to capital – has a roughly equal relationship to the returns of small and enormous stocks.
R code for calculations performed and diagrams created could be present in the net Addition to this post.
Stocks and costs: The big picture
I start with the whole period of the SBBI® dataset: January 1926 through April 2024. The left panel in Chart 1 shows the correlation between monthly returns of small stocks and the long-term Treasury bond rate of interest (hereafter “long-term interest rate” or just “interest rate”) from the start of the SBBI® dataset in 1926 through April 2024, the last available month of SBBI® returns. The right panel in Chart 1 shows the correlation between monthly returns of huge stocks and the long-term rate of interest through the same period.
The correlation between large stocks and rate of interest changes is barely negative (-0.1) and significant on the 95% level. The correlation between small stocks and rate of interest changes is just not significant. These results are robust to lagging the rate of interest change variable by one period and constraining rate of interest changes to positive values. That is, accounting for possible lagged effects and constraining rate of interest changes to potentially opposed values don’t change the outcomes.
Figure 1. Monthly returns of small (left) and enormous stocks (right) in comparison with long-term rate of interest changes, 1926 to April 2024.
These correlations are suggestive but obviously not conclusive. The long time-frame – almost a century – may obscure essential shorter-term relationships.
Table 1 subsequently shows the identical statistics, but somewhat arbitrarily grouped by a long time.
Table 1. Monthly return correlations of huge and small cap stocks with all long-term rate of interest changes.
Viewed from this attitude, the info suggest that there could also be meaningfully long periods of time during which correlations deviate from zero. I omit confidence intervals here, but they don’t include zero when correlations are relatively large in an absolute sense. Correlations normally have the expected sign (negative).
There doesn’t look like much difference in how small and enormous stocks reply to long-term rate of interest changes, with the possible exception of recent years (2020s). These results are robust to lagging the rate of interest change variable by one period. Restricting rate of interest changes to positive observations changes each the sign of the correlations and (significantly) their magnitude in some periods, as shown in Table 2. However, nothing in the outcomes of Table 2 suggests a difference within the response of small and enormous stocks to a rise in rates of interest.
Table 2. Monthly return correlations of huge and small cap stocks with positive long-term rate of interest changes.
But as we said, a long time are arbitrary periods of time. Chart 2 subsequently shows the 60-month moving correlation between the series of small, large and long rate of interest change rates for the length of the SBBI® data set.
Figure 2. Rolling 60-month correlations between small (left) and enormous (right) stocks and long-term rate of interest changes.
Two things are noteworthy. First, the charts are visually indistinguishable other than the values on the vertical axis. Small and enormous stocks appear to exhibit similar behavior in response to rate of interest changes. It is tough to flee the conclusion that small-cap stocks don’t react in another way to long-term rate of interest changes than large-cap stocks. And second, the connection between stock and price varies and may have the “wrong” sign over long periods of time.
Elimination of market effects
Could the observed similar response of huge and small stocks to long-term rate of interest changes be because of the influence of the “market” (large stock returns) on small stocks? It seems plausible that broad market effects could mask a negative response of small stocks to rising borrowing costs. By masking them out, we may get a greater sense of the impact of long-term rate of interest changes on small stock returns.
To do that, I first regress the monthly returns of small stocks on the monthly returns of huge stocks (a proxy for “the market”). I then calculate the correlation using the residuals from this regression, which reflect the non-market a part of the small stock returns and long-term rate of interest changes.[1]
Overall (1926 – April 2024), the partial correlation is again nonzero. However, as shown in Figure 3, the 60-month rolling partial correlation has mostly (though not at all times) been positive – the other of the expected sign – and sometimes large, especially recently. Controlling for “market beta” subsequently appears to affect the connection between small stocks and long-term rates of interest. However, these results are unlikely to be practically meaningful or useful.
Figure 3. Rolling 60-month partial correlations between small stocks and rate of interest changes.
Monetary policy and yields
Small-cap stocks could also be more sensitive to short-term rates of interest because their borrowing costs are more closely tied to them.
Table 3 subsequently shows the common annualized performance (in decimals, e.g. 0.03 = 3%) of small and enormous stocks through the 12 Fed tightening phases that Alan Blinder (listed in column 1) describes in his article on “soft landings.”
Table 3. Performance of huge and small stocks during Blinder’s monetary tightening.
Before the early Nineteen Eighties, a researcher might need concluded that small stocks performed higher than large stocks when the Fed raised rates of interest. The fourth column (“Difference”), which shows the difference between the returns of small and enormous stocks, has been positive during all rate hikes as much as that time.
Since then, small stocks have more often underperformed than outperformed during tightening measures, however the difference seems small.
Financial conditions
Perhaps the Fed-induced short-term and long-term rate of interest hikes should not an appropriate indicator of credit availability.
Helpfully, the Chicago Fed administers the NFCI, which measures financial conditions using a weighted average of greater than 100 indicators of risk, credit and leverage. The smaller (more negative) the worth of the NFCI, the looser (more accommodating) the financial conditions.
The general perception that small stocks are disadvantaged relative to large stocks in less favorable financial conditions suggests a correlation between the NFCI and small stock returns. And a deterioration in financial conditions reflected in positive NFCI values must have a more negative impact on small stock returns than on large stock returns.
To test this, I first remove possible NFCI time trends by differentiating the series (subtracting the previous value from each value), which mustn’t change the expected correlation sign (negative). Then I repeat the above calculations. I find no difference within the response of small and enormous stocks to changes in financial conditions, as shown in the net Addition to this blog. In no case does the change within the NFCI or its lagged value look like related to returns.
Avoid making blanket statements about small stocks and costs
As Table 1 shows, stock returns and rate of interest changes were almost at all times inversely proportional and to roughly the identical extent until the last decade following the Great Recession. Table 3 allows the identical conclusion for periods of tighter Fed monetary policy.
The first result’s theoretically justifiable. The second contradicts the favored belief that small stocks (as reflected within the small-cap index SBBI®) are particularly vulnerable to rising rates of interest.
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[1] Of course, this value is also estimated using a multiple regression of the returns of small stocks on rates of interest, taking into consideration the returns of huge stocks.
