Interest Rate in common terms signifies a fee that you will be charged for borrowing money, expressed as a percentage of the total amount of the loan. Usually, our spending decisions are likewise guided by the interest burden that we would be bearing.
Being familiar with the relationship between interest rates and the stock markets can help investors understand how changes might have an effect on their lives, and how to make better investment decisions.
Short Term and Long Term Impact
In the short term – The instant impact of a rise in interest rate is on companies with high debt in their balance sheet. The interest payment made by them rises which reduces their EPS. Thus there would be negative sentiments for such stock; resulting in a depleted stock price.
In the long term – High-interest rate would have a more sector-specific impact. The sectors which are most impacted by high-interest rate are the real estate, automobile, and all the capital-intensive industries. So, any investment in these sectors must be taken with a considerable amount of caution during the situation of high-interest rates.
So, definitely, the High-interest rate is not the best option for a country.
When the interest rate is very low, you would be obviously saving less and consuming more. The fixed deposits are no longer attractive. This might leave the banks with much lower money to lend out to the borrowers, and their profit margins would also be affected by a lower interest rate. Hence there would be fall in consumption & investment actions in the economy. The government in such a scenario would certainly resort to the printing of currency to infuse more money in the economy. This would lead to an inflationary situation in the country. At very low-interest rate the inflows are likely to be reduced.
How the Interest Rate Impacts Stocks
The interest rate that moves markets is the federal fund’s rate. In the US, the Federal Reserve increases or decreases interest rates to fight inflation or ensure it is less difficult for companies to borrow money. Investors have to figure out how to evaluate the impact of rate changes in stock prices. The Fed Funds Rate is the interest rate charged to the world’s largest banks when they lend money to each other overnight. Also known as the overnight rate, the federal fund’s rate is the way the Fed attempts to handle inflation. Other countries’ central banks do the same thing for the similar reason, e.g., in India RBI controls this rate and RBI announcements also have an impact on the Indian stock market.
Shares represent parts of a business and businesses are funded by loans. As a result, a rate rise will certainly itself decrease profitability by making their debt more expensive, cutting into their profits. They will spend more to service their debt, which means that the capital available for investment decreases.
So in whole, a rate rise will probably generally signify businesses are less profitable due to increased borrowing rates.
So what’s the interest rate we are talking about here?
Repo Rate: Repo rate is the rate at which RBI lends to its clients generally against government securities. Reduction in repo rate helps the commercial banks to get money at a cheaper rate and increase in repo rate discourages the commercial banks to get money as the rate increases and becomes expensive. Reverse Repo rate is the rate at which RBI borrows money from the commercial banks. Why is this so important? It is a way for RBI to control inflation. If repo rate is high that means the cost of borrowing is high, leading to a slow growth in the overall economy. Currently, the repo rate in India is 8%. Markets don’t like the RBI increasing the repo rates.
Increase in repo rate does not merely signify a change in the cost of capital for business, however, it also redistributes investment in favor of deposits which provide a higher rate of return. The same happens when the repo rate is cut.
So how are interest rates related to the stock market? They are contrarily connected. As the interest rates go up, stock market activities tend to come down. If a company is observed as restricting on its growth spending or is making less profit – either via higher debt expenses or less revenue – then the estimated amount of future cash flows will drop. All factors otherwise being equal, this will reduce the price of the company’s stock.
If enough companies experience declines in their stock prices, the whole market, or the key indexes that many people equate with the market, will go down. With a lowered expectation of the growth and future cash flows of the company, investors will not get as much growth from stock price appreciation, making stock ownership significantly less suitable.
However, some sectors do benefit from interest rate hikes. The banking sector is likely to benefit most due to high interest rates. The Net Interest Margins for banks is likely to increase resulting in growth in profits & the stock prices.
Sectors like Pharma and IT are less affected by interest rates. The IT sector is more influenced by factors such as currency rate fluctuations, rising attrition level, visa restrictions, competition from the large global players and margin pressures.
While setting the interest rates the RBI has to strike a balance between growth and inflation. In a nutshell – if the interest rates are high that means the borrowing rates are high (particularly for corporations). If corporate can’t borrow effortlessly they cannot grow. If corporations don’t grow, the overall economy slows down.
On the other hand, when the interest rates are low, borrowing becomes easier. This means more money in the hands of the corporations and consumers. With increased money, there is certainly increased spending which means the sellers tend to increase prices leading to inflation.
In order to draw a balance, the RBI has to consider all the factors and should cautiously set a few key rates. Any fluctuations in these rates can lead to a financial chaos.