Tuesday, January 25, 2011

The Interest Rate hike was expected – why did the market fall?

As expected, the RBI hiked the repo rate and reverse repo rates by 25 basis points. For the uninitiated, that means a 0.25% rise. The repo rate (the interest rate at which banks borrow short-term funds from the RBI) is now 6.5%, and the reverse repo rate (the interest rate that banks receive for parking short-term funds with the RBI) is now 5.5%. Two other rates – the CRR and SLR – have been left unchanged.

Why was the interest rate hike expected? Primarily because core inflation (non-food) has been rising and 6 rate hikes in 2010 had little effect in cooling off prices. Every one knows that food inflation has almost gone out of control, and the Indian housewife is at her wit’s end trying to put nutritious food on the table within the family budget.

If 6 previous rate hikes haven’t managed to cool off inflation, will the 7th (1st in 2011) fare any better? That is a good question, and the RBI Governor knows it. He took pains to explain to the media that his choices were limited. Inflation needs to be controlled, otherwise high prices of essential commodities will increase input costs for India, Inc. That would dent bottom lines and may slow down expansion and capital expenditure. The severe crack in Hindustan Unilever’s stock price today is a clear example of investor nervousness.

Raising interest costs too much at one go will increase borrowing costs and hurt the growth prospects of companies. The RBI has chosen the middle path of a gradual increase in interest rates. If inflation continues to rise, another round of rate hikes may be inevitable. Already, the RBI Governor has relaxed the target core inflation rate to 7% from the earlier 5.5%. There lies the first clue to the market’s fall today. So far, the RBI and finance ministry officials have been making positive noises about controlling inflation through monetary measures coupled with the ‘base effect’ of higher inflation in the year gone by. This was the first official admission that things haven’t worked as planned.

The second clue is the unambiguous message that the RBI Governor sent to the commercial banks: Curb lending and increase deposit rates. That may be music to the ears of retirees who stay far away from the stock market and depend on fixed income avenues. Fixed deposit rates at banks will hit the double-digit mark soon. What is meat for retirees is poison for stock market investors. The combination of higher interest rate with lending curbs will throw a spanner in the works of India’s growth story.

Rate-sensitive stocks took a beating today, and don’t be surprised if the stock market cracks further after the Republic Day holiday. As small investors, there are a couple of things we should do. One, don’t panic and sell off everything. But if you are in profit in second rung stocks, book some or all of it. Two, prepare for a bigger correction by making a list of fundamentally strong stocks that offer some Margin of Safety. Let the correction play out. The next positive trigger may come from the Budget. Buy then.

Related Posts

What the CRR-SLR-Repo cuts mean for investors
What exactly is the Margin of Safety?


sreyO... said...

A very educative article as always...every small investor, like me, should take this opportunity of correction to enter/re-enter stock markets by choosing good quality stocks. You discuss about some stocks and their future performance potential at regular interval, which is very informative as well as helps us to take decision. Thank you once again.

Subhankar said...

Thanks for your comments, Sreyoskar.

RainmanInVegas said...

This is akin to adding fuel to fire.


Money supply is grown at one end and the monetary policy is tightened at the other end.

Subhankar said...

Thanks for the link.

Political compulsions usually overrule economic prudence. This is the UPA government's way of appeasing the 'aam aadmi' - with elections in a few states around the corner.