Why do interest rate changes affect the stock market?

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Why do interest rate changes affect the stock market?

May 23, 2022
Why do interest rate changes affect the stock market?

Rate hikes have been the talk of the town lately. This is because a change in interest rates impacts almost everyone, from large corporations to common citizens.

The interest rates in the country’s financial system are governed by the central bank. It uses the monetary policy tool to adjust the interest rates and control the inflation in the economy. Inflation refers to a situation where the prices of goods and commodities rise and the purchasing power of money decreases.

The Reserve Bank of India (RBI) is the regulator of the Indian banking system. The central bank lends money to commercial banks. The interest rate at which the RBI lends money to the commercial banks is called the Repo Rate.

When inflation is high, the RBI increases repo rates, which leads other commercial banks to increase the retail lending rates. Thus, borrowing becomes costlier for businesses and households and less money will circulate in the economy. With this, the RBI aims to suck out the excess liquidity in the economy.

The rising cost of funding effects consumer spending and the demand for goods and commodities in the economy will slow down. This, in turn, will bring inflation under control.

Similarly, when inflation is low and in order to propel economic growth, the RBI decreases the repo rate and infuses liquidity into the system.


Impact on markets

It is important for investors to understand the relationship between interest rates and the stock market as it impacts their investment. This will help them make informed and better financial decisions.

Change in interest rates has a direct impact on the stock market. When the central bank raises interest rates, it increases borrowing cost for corporates, which negatively impacts their earnings. With the expectations of lower earnings, the stock prices tend to fall.

The shares of rate-sensitive sectors such as automobiles, housing, real estate, among others have a greater impact from monetary policy and interest rates.

On May 4, the RBI increased the repo rate by 40 basis points (bps) to 4.40%. (One basis point is 0.01%), in an off-cycle Monetary Policy Committee (MPC) meeting, citing inflation concerns. In order to suck out excess liquidity from the system, the central bank also announced a 50 bps increase in cash reserve ratio (CRR), which is expected to drain out Rs 87,000 crore liquidity from the banking system.

This was the first repo rate hike by the RBI since August 2018. This increase in repo rate is likely to increase the lending rates as around 40% of the loans by commercial banks are linked to it.

The surprise RBI move stunned the equity markets. On May 4, the benchmark indices Sensex and Nifty tanked around 2.3% each. Since then, both indices have crashed by around 7% each.

India’s retail inflation or the Consumer Price Index (CPI) inflation soared to a 17-month high of 6.95% in March. This was above the RBI’s upper tolerance limit of 6%.

With the unfavorable domestic and global macroeconomic situation, high crude oil prices and the Russia-Ukraine war, inflation is expected to remain higher which would lead RBI to further tightening the monetary policy.


Disclaimer: Investment in securities market are subject to market risks. Read all the related documents carefully before investing. Please refer the Risk Disclosure Document issued by SEBI and go through the Rights and Obligations and Do’s and Dont’s issued by Stock Exchanges and Depositories before trading on the Stock Exchanges. Brokerage will not exceed the Exchange prescribed limit.

R. Kalyanaraman
by R. Kalyanaraman

Chief Executive Officer

I am a sales guy at heart with utmost willingness to listen to people – customers, employees, competitors et al. Nothing gets me a bigger adrenaline rush than an interesting conversation with my customer!