The start of a Federal Reserve tightening cycle has historically produced notable changes in U.S. equity market leadership, according to an analysis by Barclays examining sector and style-factor performance around the first interest rate increase.
Market expectations have increasingly moved towards the possibility of a rate hike by the first Federal Open Market Committee meeting of 2027, despite a moderation in near- and medium-term inflation expectations.
Barclays economists, however, do not expect the Fed to raise rates during the first half of 2027. They believe recent inflation figures should be “sufficiently benign to keep most FOMC members on hold pending further evidence.”
Historical cycles point to a shift after the first hike
Barclays reviewed five Fed tightening cycles dating back to February 1994, comparing equity returns during the three months and one month before the first rate increase with performance over the equivalent periods following it.
The findings suggest that “the onset of a Fed hiking cycle has historically marked a clear inflection point for equity leadership.”
During the three months preceding the initial hike, the S&P 500 recorded a median gain of 2.2%, while small-cap stocks were broadly unchanged.
Energy and Industrials were the strongest sectors ahead of tightening, with both generating median returns above 7.5%. Communication Services was among the laggards, declining by approximately 2%.
Small caps and Financials weaken after tightening starts
Performance shifted considerably once the Fed began raising rates. Small-cap stocks underperformed their large-cap counterparts, with the Russell 2000 recording a median decline of 7.2% during the quarter after the first hike. The S&P 500, by comparison, posted a median loss of 3.9%.
Financials delivered the weakest sector performance, falling a median 8.4%. Defensive areas including Health Care, Utilities and Consumer Staples also came under pressure.
Energy was the only sector to produce a positive median return following the first increase, although its gain was limited to 0.3%.
Barclays linked the weakness in Financials to tighter financial conditions and flatter yield curves, which can put pressure on bank lending margins. Defensive sectors, meanwhile, experienced valuation de-ratings as the Fed’s decision to tighten policy indicated that economic conditions were strong enough to support higher rates.
Value has historically held up better than Growth
Style factors also showed distinct patterns around the beginning of tightening cycles. Barclays said Value has “generally fared better than Growth, especially within small caps.”
Among large-cap stocks, Growth underperformed Value during the two quarters following the first rate hike. The divergence was stronger among smaller companies, with the rotation “even more pronounced among small caps, where Growth trails Value sharply within the first two months of the hiking cycle.”
Momentum has typically performed well in the period leading up to the first increase before moving into a more range-bound pattern afterward.
Meanwhile, the Fama-French small-over-large factor has historically weakened for roughly two months following the first hike before beginning a more sustained recovery.