Interest is nothing more than the cost someone pays for the use of someone else’s money. Homeowners, credit cards users etc know about this scenario very well. They borrow money from bank and in return they pay interest to bank for using the privilege. Interest rate is an integral part of our spending habit as we borrow from the bank for buying house, cars, house old items etc. For the business community interest rate is also very important as they borrow money from bank for investment activities like capacity expansion, setting up of plants, acquisitions, modernization etc. So interest rates play a critical role in a business’s profitability and hence, on stock prices.
SO WHAT INTEREST RATE AM I TALKING ABOUT HERE?
REPO RATE. This is the interest rate that applies to investors. This is the cost that banks are charged for borrowing money from The Reserve Bank of India. Why is this number so important? It is the way RBI attempts to control inflation. Inflation is caused by either excess Aggregate Demand or cost push factor (supply side factors), which causes prices to increase. By influencing the amount of money available for purchasing goods, RBI can control inflation. Basically, by increasing the Repo rate, the RBI attempts to lower the supply of money by making it more expensive to obtain. Though sometimes CRR cut also acts a stimulant in lending rate changes, repo rate has an edge over CRR in terms of deciding lending rates.
HOW DOES IT AFFECT STOCK PRICES?
Interest rate and stock prices have an inverse relationship or I can say their relationship is like a SEESAW. Changes in the Repo rate affect the behavior of consumers and businesses, but the stock market is also affected. One method of valuing a company is to take the sum of all the expected future cash flows from that company discounted back to the present. To arrive at a stock’s price, take the sum of the future discounted cash flow and divide it by the number of shares available. This price fluctuates as a result of the different expectations that people have about the company at different times. Because of those differences, they are willing to buy or sell shares at different prices.
If a company is seen as cutting back on its growth spending or is making less profit – either through higher debt expenses or less revenue from consumers – then the estimated amount of future cash flows will drop. All else being equal, this will lower the price of the company’s stock. If enough companies experience declines in their stock prices, the whole market, or the indexes (like the BSE Sensex or NSE Nifty) that many people equate with the market, will go down.
Following points are also worth taking note-
The following data depicts the changes made by The RBI since September 2010 and its impact on Sensex.
The above table shows that Sensex reacted negatively whenever repo rate was hiked post September 2010. As a matter of fact, on 03-May-2010 when The RBI hiked repo rate by 50bps, the Sensex plunged by 460 points. However, when repo rates were upped to 8.25 percent and 8.50 percent respectively from their previous levels, market in fact reacted positively as India was driven by strong economic growth during that time and the rate has reached to its stability. A 50 basis point hike in the rates on 28-Jan-14 failed to create any stimulus in the market as Sensex moved only 24 points.
Change in repo rate has “Mumbo Jumbo” effect on stock market. Increase in repo rate not only increases the cost of debt/capital for business but it also shifts the investment in favour of deposits which offer higher rate of return. The same happens when the repo rate is trimmed. The market may or may not react significantly to a rate cut of 25 bps but the real impact comes over only after a period of time.
2015 will be a good year but not as good as 2014 was, since 2015 may not see some wonderful rallies which took Sensex and Nifty to their lifetime high. However one thing that could trigger a rally in Sensex and Nifty will be the possible rate cut by the RBI in the New Year. Apart from Banking and Finance companies being the direct beneficiaries of the rate cut, companies with high debt capital structure will also benefit. Expecting a rate cut by the RBI, I recommend the readers to consider the following stocks:
DISCLAIMER: Among many other factors to be considered while investing in stocks market, interest rate is one of them. One can never say with confidence, therefore, that an interest rate hike will have an overall negative effect on stock prices.
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