The Reserve Bank of India (RBI) is mandated to keep the Indian economy running smoothly. To do this, it has several tools at its disposal. But the bank prefers using interest rates because it is the most effective tool. Changes in interest rates affect almost all the markets in the economy. Notably, it impacts the forex, commodity, and stock markets.
When the economy is sluggish, RBI cuts down the rate to make borrowing cheaper. Borrowers may choose to spend the money on buying consumables or assets. They may also opt to invest part of the borrowed money in stocks. If they choose to invest in stocks, it increases the demand and pushes the prices up. Such a move rewards stock market investors with better returns.
Interest Rates vs. Stock Market
The best instance pitying interest rates vs stock market was during Covid 19 pandemic. At that time, economic activities in the country dropped to the lowest. RBI responded by slashing interest rates, which made the country’s economy rebound strongly. When inflation is too high, investors move their money from the stock market to alternative investments like high-yielding bonds and treasury bills.
RBI may try to control inflation by increasing the interest rate to help mop up excess liquidity. The increased rate cools the hot economy down.
Note that High-interest rate affects all sectors of the economy. It causes business loans, car loans, and mortgage rates to go up. As a result, it forces businesses to halt expansion plans. Such ventures will look less profitable, bringing down stock prices. Further, high-interest rates make saving instruments such as fixed deposits and saving accounts look more attractive. So they attract funds away from the stock markets, causing the prices to plummet even further.
But the rate hikes do not always impact stocks negatively. Some sectors, especially the financial sector, will have their stock price increase because high rates increase their profit margins, making them look profitable. Tech companies and start-ups’ stock prices will plummet immediately after the interest rate increases.
Typically, high-growth companies invest most of their cash in expanding their businesses. As a result, they fund their daily operations through borrowed funds. Therefore, when the cost of borrowing increases, it clips their wings, and they may find it expensive to borrow and struggle to stay afloat. If they decide to borrow at higher rates, most of their returns will be directed to meeting interest expenses.
Fortunately the rising interest rate does not sometimes lead to losses for stock investors. If you diversify your portfolio by investing in index funds, you are unlikely to incur losses when the stock market is in turmoil.
Note that interest rate changes will affect the stock market and the entire economy. But the impact will be experienced sooner in the stock market than in any other markets. The high rates will affect stock earnings save for companies in the financial sector. Also, high-interest rates mean that future discounted valuations will be low.
What other things can happen?
Other than the interest rate, RBI may set the discount rate. This is the rate it charges for its overnight lending. Typically, banks will borrow from RBI to meet their cash demand shortfall. This rate may be higher than the prevailing interest rate when the bank wants to discourage other banks from borrowing from it. Instead, it encourages them to borrow from other institutions at a lower rate.
By increasing the discount rate, RBI elevates the cost of short-term borrowing. A high discount rate means financial institutions must spend more money to finance businesses. So they must increase the rate at which they lend to businesses. Of course, fewer businesses will want to borrow such high-interest capital. Those who decide to avoid it miss out on emerging business opportunities requiring more finances. It reduces their profitability and further drives their stock prices south.
From this discussion, it is clear that interest rates and stock markets relate in a unique way. For instance, as the rate increases, firms become less profitable since they spend most of their income paying high-interest rates. They may also need more capital to take advantage of emerging business opportunities. These two aspects make their share prices on the stock market plunge.