Interest rates and its impact on financial markets
Interest rates of currencies, fixed by the central banks impact the availability of that currency and in turn the stock markets of that country. In case of widely used currencies like US Dollars or British pounds, the impacts can be seen across different markets. In this post, we will see how rates affect the markets.
Recently, US FED decided to turn hawkish by proposing to increase the interest rate associated with US dollars. The impact of this decision echoed across countries and all the major indices fell. Thought it will take some time to impact the general economy, Markets will react swiftly to these information. We should understand how and why this impacts the markets. Everyone trading the markets understand that institutions control and drive the markets. Institutions participate in the market to “maximize their profits as and when opportunities present.
In this view, we can understand how much important this interest rate is. Let us say, you have Rs. 1000 and you want to save it in a bank. One bank is offering 4% and the other bank is offering 5%. Now which bank would you choose to invest your money? Obviously, you will choose the second bank which offered the higher interest rates. The same logic can be applied to the fed rates.
If RBI offers higher interests, banks also offer higher rates to its depositors and loans will get costlier, if so, more people will invest their money in Fixed deposits or any other form of bank deposit. Money thus will elude stock market. People may also choose to liquidate their holdings to deposit them in banks in hope of making risk free higher returns.
Now since most foreign investments to any foreign market comes from the United states, if US offers better returns on its currency, institutions convert their money into US Dollars, Creating a demand for the currency and pushing USD Higher. All the other currencies will fall with respect to rise in dollar prices. This will also affect commodity prices, but comparatively to a lesser degree than equities market.
Bonds also experience a fall in price, compared to the rate of increase in interest rates. Let us say, you have purchased a bond for Rs. 1000 and it pays an interest of 7%, if the central bank increases interest rates, New bond issues will fetch a higher rates and investors will dump the old bond for new ones causing a fall in price.
–> Increased rates cause reduction in profit margins, especially sectors which depend on debts for capital expansion, like power generation and NBFCs.
–> It reduces the spending abilities of salaried class as interest for all their EMIs become high.
–> It can impact growth of the economy as companies find it hard to get loans.
–> If unchecked, higher interest rates can have major economic impacts like higher non performing assets, higher unemployment rate. Impact can be severe on small businesses