The Federal Reserve’s recent decision seems to have made limited impact on the broader stock market at first glance. The S&P 500 has seen a slight decrease, trading down by 2 points, contrasting with its earlier position.
In a shift, smaller cap stocks have responded more positively to the Federal Reserve’s forecast. The Russell 2000 index, which focuses on small cap stocks, has risen by 1.7% for the day, reaching its highest level since November 2024.
Federal Reserve Updated Forecast
The updated forecast from the Federal Reserve now anticipates two further interest rate cuts this year as opposed to the previously expected one. This positive performance in small cap stocks places the Russell 2000 close to its all-time highs.
The Federal Reserve’s new forecast is a clear signal to shift focus toward small-cap stocks, which are highly sensitive to interest rates. We should be looking at buying call options on the Russell 2000 index (RUT) or its ETF (IWM) with expirations in October and November 2025. Today’s jump in call volume to nearly three times the 30-day average confirms that many traders are already making this move.
This dovish pivot from the Fed is supported by recent economic data that makes further cuts very likely. The August 2025 Consumer Price Index report showed core inflation falling to 2.8%, its lowest point since mid-2022. This, combined with a recent jobs report showing payroll growth slowing to under 100,000, gives the Fed plenty of reason to ease financial conditions.
Divergence Trade Opportunity
The S&P 500’s flat performance suggests a divergence trade is now on the table. Before today, the Russell 2000 had gained only 4% year-to-date, trailing the S&P 500’s 12% rise, and this Fed decision could be the catalyst for small caps to finally close that gap. We can structure this view by going long Russell 2000 futures and simultaneously shorting S&P 500 futures.
We saw a similar pattern play out in late 2023, when the market first began pricing in the Fed’s pivot to rate cuts for 2024. That period saw small caps, which had underperformed all year, stage a powerful rally into year-end that outpaced large-cap stocks significantly. History suggests these rotations can gather momentum quickly once they start.
With more certainty around the Fed’s path for the rest of the year, we can also expect broader market volatility to decline. The VIX index is already reflecting this, dropping below 14 for the first time in several months. Selling out-of-the-money put spreads on the IWM is a good way to take advantage of both this expected stability and the underlying upward trend.
