Relationship between interest rates and stock markets

Inflation is one of the most heard and serious concerns that the world is battling today. The series of events from the start of covid has led to high inflation levels across the globe and countries have been in top gear to battle the same. One of the many responses to curb the effects of inflation is increasing interest rates. This has a direct impact on the EMIs that need to be paid by an average person. But the other impact is also in the stock markets. While the inflation levels go down gradually with the increase in interest rates, the reaction from the stock markets is immediate. This relationship between interest rates and stock markets is explained hereunder.

What is the interest rate?

The term interest rates are very common in financial jargon. It is the rate at which the lenders lend money to the borrowers for the tenure of the loan. When the RBI increases the interest rates, it does not directly increase the rate at which banks lend money to the average customer. RBI increases the repo rate which is the rate at which RBI lends money to the commercial banks of the country. This increase in the cost of borrowing is passed on to the ultimate customer in the form of increased lending rates across the country. 

Read More: Why do central banks raise interest rates to combat inflation? 

How does interest rate affect stock prices?

When the central banks announce an increase in interest rates, the immediate impact of the same is a fall in stock markets. It is a result of the ripple effect on account of rising interest costs that the stock markets react adversely to the news. This reaction from the stock markets on account of rising interest rates is explained hereunder.   

1. The reduced purchasing power of people at large

With the rise in interest costs, the average investor is hit by a higher outflow on their existing borrowings. The increased cost of borrowings will result in lower disposable income in the hands of the investors and therefore lower investments in the stock markets. This further leads to a reduction in the demand for stocks affecting their prices and a bearish mood in the stock markets. 

2. Increase in the cost of borrowing that leads to lower profits

The corporates are also hit by the growing interest rates as their cost of borrowings increase. The higher interest cost paid on existing loans eats into the net profits of the company. Also, as the cost of new loans will increase, businesses will have to look for alternate cheaper options to raise finances or opt for other measures like budget cuts, curbing or postponing their growth and expansion plans, etc. 

The lower disposable income in the hands of the consumer further affects the demand for overall goods and services in the country again leading to a dip in profits. A favourable financial report for a quarter or more will have an adverse effect on the stock prices adding to the bearish trend in the country, Therefore, businesses face more disadvantages in a growing interest rates scenario. 

3. Other investment options look more lucrative

The rise in interest rates is usually due to rising inflation which lowers the real returns earned by investors from the stock markets. This leads the investors away from the stock markets due to high volatility and lower returns towards other investment options that provide more or less stable returns as well as the safety of their corpus. 

Therefore, fixed income investment options like PPF, NSC, NPS, Sovereign Bonds, debt funds, etc. start to look more attractive, and investments in such options see an increase as compared to investments in stock markets. This further impacts the demand for stocks and ultimately their prices. 

4. Growth stocks take a hit

Growth stocks are the stocks of companies that are expected to perform better than the industry average and are on the cusp of a high growth rate and profits. These companies will need finances to meet their goals and growth trajectory but in the rising interest rate scenario, they are hit badly due to increased borrowing costs. 

Value stocks on the other hand are stocks of well-established companies that do not see a drastic shift in the demand for their products and therefore are able to provide more or less stable returns in the form of dividends. This increases demand for such stocks when interest rates increase. 

Moreover, stocks of banks, the insurance sector, etc. see a rise in demand as they are projected to earn higher profits due to increasing interest rates. This adds to the demand for such stocks and increases their stock prices. 

Is investing in stocks amid high interest a bad choice?

The volatility of stock markets often deters an average investor from tapping into the high-earning potential of investment in shares. Inflation is part of every economy and is even considered to be a boon in some cases. Thus, the central bank’s response by increasing interest rates should be treated as part of the normal course of business. Most investors think that due to the high volatility of stock markets and increasing interest rates, stocks are a bad investment option but such is not the case. 

Stock markets tend to stabilize in the long run and therefore, even in bearish markets due to rising interest costs, investors should aim for investment in stocks with a long-term investment horizon. Value stocks are a good investment option in such a scenario to provide good returns as well as create a stable portfolio. Growth stocks, on the other hand, may face strong hits due to rising interest costs but a company with strong fundamentals and a good business model should be preferred for investment as when the markets stabilize in the long run, such companies have the potential to provide exponential returns. 

Conclusion

Interest rates and stock markets have an inverse relationship and move in a constant cycle of ups and downs. The key to making profits from stock markets in such adverse situations is to aim for long-term returns and avoid the buzz of short-term volatility. Most experts across the globe including the IMF are bullish on the Indian economy and expect it to soar despite the rising inflation globally. Therefore, investors can pick quality stocks when they are available at lower margins to create a robust portfolio with a long-term investment horizon. 

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