What is Interest Rate?
Essentially, interest is nothing
more than the cost someone pays for the use of someone else's money. Homeowners
know this scenario quite intimately. They have to use a bank's money, through
a mortgage, to purchase a home, and they have to pay the bank for the
privilege. Credit card users also know this scenario quite well -
they borrow money for the short-term in order to buy something right away. But
when it comes to the stock market and the impact of interest rates, the term
usually refers to something other than the above examples - although we
will see that they are affected as well.
The interest rate that
applies to investors is the Federal Reserve's funds rate. This is the cost that
banks are charged for borrowing money from Federal Reserve banks. Why is
this number so important? It is the way the Federal Reserve (the
"Fed") attempts to control inflation. Inflation is caused
by too much money chasing too few goods (or too much demand for too little
supply), which causes prices to increase. By influencing the amount of money
available for purchasing goods, the Fed can control inflation. Other
countries' central banks do the same thing for the same reason.
Basically, by increasing
the federal funds rate, the Fed attempts to lower the supply of money by
making it more expensive to obtain.
Stock Price Effects
Clearly, changes in the federal
funds rate affect the behaviour of consumers and businesses, but the stock
market is also affected. Remember that 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 Dow Jones Industrial
Average or the S&P 500) that many people equate with the market,
will go down.
Investment Effects
For many investors, a
declining market or stock price is not a desirable outcome. Investors wish to
see their invested money increase in value. Such gains come from stock
price appreciation, the payment of dividends - or both. With a lowered
expectation in the growth
and future cash flows of the company, investors will
not get as much growth from stock price appreciation, making stock ownership
less desirable.
Furthermore, investing in stocks
can be viewed as too risky compared to other investments. When the Fed raises
the federal funds rate, newly offered government securities,
such Treasury bills and bonds, are often viewed as the safest
investments and will usually experience a corresponding increase in
interest rates. In other words, the "risk-free" rate of
return goes up, making these investments more desirable. When people
invest in stocks, they need to be compensated for taking on the additional risk
involved in such an investment, or a premium above the risk-free rate. The
desired return for investing in stocks is the sum of the risk-free rate and
the risk premium. Of course, different people have different risk
premiums, depending on their own tolerances for risk and the companies they are
buying into. In general, however, as the risk-free rate goes up, the total
return required for investing in stocks also increases. Therefore, if
the required risk premium decreases while the potential return remains the
same or becomes lower, investors might feel that stocks have become too risky,
and will put their money elsewhere.
US Fed Rate hike impact on India
After 2008 crisis, US Fed slashed the interest rates
to 0.25% to support the economy. Since then US Fed has kept interest rate
constant to increase liquidity in the US market. The emerging markets were the
major beneficial of low-interest rates since investors invested in emerging
markets because US market was fragile. But now the US economy is improved and
on 17 September, Fed will contemplate to raise interest rates. This may lead to
capital outflow from emerging markets since investors will prefer to invest in
US market both in debt (better yield) and equity (better economic growth).
Considering the strong growth in India, it is unlikely that the long-term
investment story of Indian will get impacted due to this hike. However, US
Fed’s decision may have a temporary negative impact on Indian markets in the
following ways:
Impact on Indian Rupee
Indian Rupee will depreciate if US fed will raise the
interest rate. US interest rate hike will be an indication that US economy is
in good shape. Thus foreign investors in Indian markets will withdraw their
money and invest in US market. In addition, the depreciation of Indian Rupee
will lead to higher current account deficit and higher inflation.
Impacts on Indian equity market
On the fear of the possible US Interest rate hike equity market
has already corrected recently. The hike in US interest rate hike will
depreciate the Indian Rupee against US dollar. The foreign investors who have
invested in Indian market will fear that the depreciation in Indian Rupee will
wipe out their profits. Thus, they will start book profits.
For example, let’s say an investor invested USD
1,00,000 a year ago in India when the exchange rate is Rs 61 per US Dollar; in
Indian Rupee he invested Rs 61,00,000. In one year, he made 10% return and his
portfolio rose to Rs 67,10,000. After US interest rate hike, let say Indian
Rupee depreciated to Rs 69 per US Dollar; his portfolio in US Dollar will dip
to USD 97,246.38 and he will incur a loss of USD 2,753.62. Thus, he will prefer
to book profits.
However, the IT and pharma are the biggest beneficiary of the
Rupee depreciation and retreating US economy.
Impact on Indian Debt
Market
There is a huge difference in interest rate in India
and US. The policy rate is India is 7.25% while in the US it is 0.25%.
Theoretically, an investor can borrow money from the US at 0.25% and invest in
India for 7.25%. Thus, he will earn 7% return after paying back the borrowed
money. The subsequent interest rate hikes by US Fed will reduce this gap and
foreign investors will show reluctance to invest in India since the risk-reward
will become less favourable. This is in addition to lower returns due to
depreciation of the rupee.
Conclusion
India is not isolated from the impact of US interest
rates. There may be some temporary capital outflow from the Indian market if US
Fed hikes the interest rate. In long-run, Indian economy is attractive with a
growth of 7% and inflation under control, thus investors will not be able to
stay away from investing in India.
