The market volatility that we saw in the first half of 2025 gave way to a steadier third quarter. Rather than being distracted by headlines out of Washington, investors chose to remain focused on economic data that showed a slowing labor market and relatively contained inflation. That setup created room for the Fed to lower interest rates at its September meeting for the first time this year.
When the Fed lowers interest rates, it quickly impacts loans tied to short-term rate benchmarks. These types of loans are often used by smaller companies to finance their businesses. The Russell 2000 index of small-cap companies led markets higher during the quarter, rising +12.0%, as investors anticipated that lower financing costs would lead to higher future earnings. While small-cap companies were the biggest beneficiaries, interest rate cuts also helped drive gains in other asset prices as well.
As we transition into a period of lower short-term interest rates, it will reduce earnings potential from holding cash and short-term bonds, but it could also continue to support higher prices for other assets, like equities. While the environment changes, our commitment to building well- diversified portfolios that prioritize long-term outcomes does not.
After a tumultuous spring, markets experienced a relatively calm summer period. Events in Washington continued to figure prominently in the headlines, but investors opted to focus more on what they were seeing in the actual data.
To that end, the inflationary pickup that many commentators predicted when President Trump unveiled his new trade policies has yet to materialize. Inflation does remain elevated above the Fed’s 2% target, but it’s been driven by services categories, rather than the goods most likely to be impacted directly by tariffs. An environment where inflation runs somewhat hot for a prolonged period is not ideal, but we certainly haven’t seen anything like the inflationary spike experienced in 2021 & 2022.
However, we did see a slowdown in hiring over the summer, which may be a function of the uncertainty brought on by those changes to trade policy, along with the impact of stricter immigration enforcement. Rather than waiting to see if this progressed into widespread layoffs, the Federal Reserve chose to act quickly, cutting the Fed Funds Rate target by 0.25% in mid-September and signaling further cuts are likely in their upcoming meetings.
As the Fed lowers rates, it quickly impacts loans tied to short-term rate benchmarks. These types
of loans are often used by smaller companies to finance their businesses. With less money going toward interest costs, these companies may be able to retain workers and/or increase their profits. Investors anticipated this in the third quarter, driving the Russell 2000 index of small-cap companies up +12.0%.
And small-cap companies were far from the only beneficiaries of the Fed’s actions. The S&P 500 large-cap index also rose +7.8%, while the MSCI All Country World ex-US index rose +6.3%. Strength in these indexes was supported by declines in long-term interest rates, which are an important input into how some investors value stocks; as yields fell, these investors were willing to pay higher prices for stocks.
Long-term rates can also influence the pricing for financial products, like fixed-rate mortgages. As yields on the benchmark 10-Year US Treasury bond fell during the quarter from a July 15 high of 4.50% to 4.16% on September 30, the national average 30-Year Mortgage Rate also fell from 6.75% to 6.30%, helping to improve affordability for prospective new homeowners.
Nevertheless, it’s important to understand that these longer-term rates are set by the market,
not by the Fed. We were reminded of this as recently as last year, when the Fed cut the Fed Funds Rate target by 1.00%. Instead of declining alongside short-term rates, the yield on the 10-Year U.S. Treasury went the complete opposite direction and rose by 0.88% from the date of the first cut (9/18/24) through the end of the year.
We think this happened because investors shifted their focus from the Fed’s actions to the potentially inflationary and deficit-enlarging policies they were hearing from both Presidential candidates on the campaign trail. There is no Presidential election to worry about this year, but it does serve as a reminder that the Fed’s power is limited. Ultimately, the market focuses on the long term, just as we do.
Going forward, we’ll remain focused on the relative attractiveness of different market segments and how they may be impacted by changes to the environment. For example, as we transition into a period of lower short-term interest rates, it will reduce earnings potential from cash and short-term bonds, but it could also continue to support higher prices for other assets, like equities.
That said, the S&P 500 is now up +13.7% YTD through 9/30, after rising +24.2% in 2023 and +23.3% in 2024. The SPY index fund tracking that group of stocks now trades at 24x their expected earnings over the next 12 months, which is over 20% greater than the 10-year average of 19x. When we see this, risk management comes to mind.
While we certainly want to participate in further upside, if it comes, we also work to ensure that your portfolios are well diversified across asset classes, geographies and investment styles, so that you’ll be prepared for a time when the economic environment or investor sentiment reverses course.
In the meantime, we’re always available to discuss your allocation, strategy or any questions you may have.
All performance/pricing data sourced via YCharts and SPY valuation sourced via Koyfin, as of 10/1/25.
