The Impact of Interest Rates on Stock Market Performance

Overview

What if you wake up one day and find out that the interest rates have just been dropped. How will it influence your investments?




At first, lowered interest rates may sound like a good things. But it is not the whole truth and can confuse investors. The impact of such event may not as simple as it always seems. 

The rate of interest is a powerful factors in the finance world. Basically, it changes everything, from consumer spending limits to how businesses earn. When central banks make any change in these rates, it can have hugely influence the affairs of stock market. 

In this blog, we will study what happens when interest rates change and how it could affect your investments. Further, it will review what is the interrelation between stock market and interest rates of a country. So let’s jump in without wasting a jiffy.

Also Read: Top Stock Market Indicators Every Investor Should Follow

What Is Interest Rate?

Just imagine, you give your friend 100 rupees, thus you’re doing them a favor. But to make it fair, you ask them to pay back a little extra as a thank-you.

That extra amount is called “interest.”

So, what exactly is an interest rate?

It’s simply the percentage of the extra money (interest) you get when you lend your money out.

How Interest Works in Real Life

When you borrow money for anything like for a car, house, or college, the bank puts extra fees as interest. It means you’ll have to pay back a little extra than you take.

On contrary, if you save or even invest money like in a savings account, the bank gives you extra money as interest to hold you with them. This also helps your savings grow over time.

In short, banks pay you interest as a thank you for letting them use your money. The interest rate is the extra amount in a percentage they agree to pay or charge.

Let’s make it easier to understand:

When you deposit money: The bank gives interest for letting them use your money. For example, if the interest rate is 5% per year, as investors, you can make Rs. 500 on your invested Rs. 10,000 at the end of every year.

When you borrow money: The bank adds a fee as their own interest. So, if you take loan of Rs. 10,000 at a 10% interest rate, you may end up paying them Rs. 1,000 extra at the end of every years.

Sounds about right? Now let’s learn first about repo rate, a big element to understand interest rates.

What Is the Repo Rate?

The Reserve Bank of India (RBI) sets an element, known as the repo rate in India. This number influences how much banks can charge loan borrowers or pay depositors in interest.

But why does the repo rate matters to you?

Well;

Higher repo rate

You may notice that loans become more costly. As a consumer, if you decide to take a loan these times, you may end up paying more in interest. 

Lowered repo rate

This is the period when loans become cheaper. This period allows people to borrow more and spend more, thus helping the economy grow.

RBI, by making changes in the repo rate, controls how much it costs to borrow money throughout the country.

Why Interest Rates Matter

When it comes to how important is interest rate, think of it this way. Interest rates are like the heart of an economy. It controls the flow of money, setting how people spend and save. Here is a few more points to explain it better;

Borrowing Money

When a country’s interest rates are low, borrowing money goes cheaper. In general, it makes easy for people to buy things, such as homes or cars. But when it goes up, money borrowing becomes more expensive, thus people only spend on essential stuff, holding on their big purchase decisions. 

Saving Money

During the time of higher interest rates, people save more money. On the other side, when interest rates are low, savings becomes spendings and people go for spending or investing options more. 

Boosting or Slowing the Economy

Basically, central banks change interest rates to help boost an economy. Aforementioned, when interest rates hype people to spend and borrow more, creating more money flow in markets. But what if the economy is getting too hot, higher rates can slow things down.

Controlling Inflation

If prices are rising too quickly (that’s inflation), central banks might increase interest rates. The result, expensive borrowings, eventually slowing down spendings, keeping the prices from going up too fast.

Interrelation Between Interest Rates and Stock Market

Now the big question – do interest rates influence the stock market?

Yes! Till now we understood that interest rates can hugely impact on the stock market. But it is important to know its interrelationship for investors to get the logical side. 

So here’s how they connect:

Cost of Borrowing

If the interest rates are higher, investors are more likely to have less money to invest or choose it to save for emergencies. This can lower the money flow, profits, and hurt their stock prices.

Let’s take an example. If a company look out to loan ₹1 crore for a new project. Now if the interest rates rises up to 8% – 10%. This means the bank will pay a lot more charges as interest, thus hurting their profits.

Investment Decisions

Investors compare how much they can earn from stocks vs. bonds. When interest rates are low, stocks look better. When rates go up, bonds offer better returns, so stocks may look less attractive.

Exactly, this happened in 2022 when U.S. rates went up, and foreign investors took money out of Indian markets, it can lead to stock prices to drop by 6%.

Consumer Spending

When interest rates rise, people spend less. Loans for things like homes or cars become more expensive. When people spend less, businesses sell less, and their stock prices can go down.

Market Sentiment

Interest rates affect how investors feel. If rates go up, people worry about inflation or the economy slowing down. This can make stock prices drop as investors get nervous.

Sector Impact

Different businesses react differently to changes in interest rates. For example, utility companies may suffer if rates rise because they borrow a lot. But banks may do better, as they can charge more for loans.

Valuation of Companies

A company’s valuation or its stock price are commonly calculated on how much money it can or will make in the future. Suppose when interest rates of any economy go up, they use a higher rate to find out its future earnings. So in such cases, even if a company is doing well, its stock value might drop.

Economic Growth

Lower interest rates help the economy grow because borrowing money becomes cheaper. People and businesses spend more, which helps the stock market. For example, when the RBI cuts rates, more money flows into Indian stocks as investors look for better returns.

The relationship of both interest rates and stock market is a two-way thing, meaning if one face changes, the other surely gets affected. It can hugely influence how businesses works and also changing the spending consumer habits, thus affecting stock prices. 

Interest Rates and the Bond Market

Not only the stock market, but interest rates influence the bond market too. There’s an important rule here: when interest rates go up, bond prices usually go down—and vice versa.

Why It Happens:

The bond rules are quite simple to understand: most bonds pay a fixed amount of interest (a coupon) to the holders. How it happens is when a new bond opens with higher interest rates, the old ones which has lesser rates become obsolete and less attractive to investors. Let’s see it with an example: if you have invested in a bond that pays 5% interest and a new bond issued at 6%, it will lead to price drop to match its new higher rate.

What Happens in the Market?

Suppose, if an investor thinks that interest rates are going to go up, it may lead them to sell off their bonds under suspicion that they might fall. On the other hand, when rates go down, older bonds become more valuable since they pay better returns than the new ones.

Impact on Investors

For investors who rely on income from bonds, rising interest rates can mean lower returns. New bonds will pay more than older ones. This might lead some investors to sell their bonds and invest in stocks, hoping for better returns.

Current Situation in India: Interest Rates and the Stock Market

Right now, the global economy is changing rapidly. There’s a good chance the U.S. Federal Reserve might drop their rates soon. If that happens, it could bring more foreign investors to India, looking for better returns. In fact, on September 20, 2024, foreign investors bought ₹14,064 crore worth of Indian stocks after hearing about potential rate cuts.

But here’s something important to know: when interest rates go up, markets often dip at first. For example, after rate hikes, the Nifty index often falls. However, history shows that these dips don’t last long. Over the past 34 years, Indian markets have bounced back, even when U.S. interest rates have changed a lot.

Also Read: Top 5 Stock Market Strategies for Long-Term Growth

Market Volatility and Managing Risks: Interest Rates on the Stock Market

Let’s face it: any changes in interest rates can lead to market volatility in the stock market. When RBI takes a decision to either inflate or deflate rates, it disturbs the balance between supply and demand. This can make stock prices move suddenly, just like a see-saw.

But here we have listed a few ways to manage these changes:

Diversification:

It’s super important to keep your investments spread across different assets, sectors, and even countries. If seen using an example, when interest rates inflates, bond prices might go down, but some stocks could still do well. Thus, diversification of your investment portfolio can help you shield your portfolio from such sudden drops.

Fixed-Income Allocation:

When interest rates go up, shorter-duration bonds or floating-rate investments are a good choice. These are less affected by rate hikes, so they’re safer when borrowing costs rise.

Sector Rotation:

Some sectors, like finance, do better when interest rates are high. Others, like real estate or utilities, might struggle. Shifting your investments between sectors can help you benefit from these changes.

Hedging:

Hedging helps protect against sudden rate changes. You could use strategies like interest rate derivatives or shorting securities linked to interest rate moves.

The key takeaway: Whether it’s interest rates or other factors causing market ups and downs, it’s important to protect your investments from risk.

Conclusion

So, as we wrap up, it’s clear why understanding interest rates is key before jumping into the stock market. When rates rise, we might see short-term drops and higher costs for companies. But when rates fall, it can boost growth and attract more foreign investment.

Remember – keep an open eye on changing rates to safeguard your investment.

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