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Friday, December 16, 2011

RBI pauses interest rate hikes – why did the stock market dive?

Stock markets and interest rates have a love-hate relationship. Markets love low interest rates, but detest high interest rates. ‘Low’ and ‘high’ are relative terms. As a very rough thumb rule, a Repo rate of 5% or lower can be taken as a ‘low’ rate; 7% or higher can be considered a ‘high’ rate.

In Jul ‘08, the Repo rate (the interest rate payable by commercial banks when they borrow money from the RBI) had peaked at 9% – more than 6 months into the previous bear market that lasted from Jan ‘08 to Mar ‘09. Thereafter, Repo rates and Reverse Repo rates (interest rates payable by RBI when they borrow money from commercial banks) were gradually reduced till the Repo rate hit a low of 4.75% in Apr ‘09.

By Mar ‘09, when the Repo rate was at 5%, the stock market reversed direction and started rising. The ‘lag’ effect of interest rate changes are evident from the above data. Bear markets start well before interest rates hit their peak; bull markets start before interest rates drop to the bottom.

The next increase in the Repo rate came only in Mar ‘10, when it was raised from 4.75% to 5%. The bull market was already a year old by then. Thereafter, 12 more rate increases – the last of them in Oct ‘11 – took the Repo rate to a high of 8.5%. By then, the bear market from the top of Nov ‘10 was almost a year old.

Why do stock markets hate high interest rates? Because the cost of doing business increases for every one, and profits take a hit. Capital expenditure is postponed, which hurts growth and in turn, hurts profits. When earnings decrease, EPS reduces. P/E ratios become higher, which induces selling of stocks and shifting of investments to bank fixed deposits at high rates.

Two months back, RBI last increased the Repo and the Reverse Repo rates by 25 basis points (0.25%). The stock market had expected the hike, but appeared to celebrate the news by moving up. That seemed to go against logic. Stock markets are supposed to hate high interest rates. What may have caused the celebration was a hint by the RBI that they may not raise rates further if inflation rate started to moderate.

Inflation rate has started to drop, though it continues to remain high. Food inflation has fallen quite remarkably – whether due to seasonal reasons or high ‘base effect’ or both. The high interest rates caused GDP growth to slow down and de-growth in IIP (Index of Industrial Production). So, it was no surprise that RBI left the interest rates unchanged, and hinted that rates may be lowered henceforth to spur growth. Instead of celebrating, the stock market dived – again appearing to defy logic.

What happened? Many market players had expected a cut in the CRR (Cash Reserve ratio – the percentage of total deposits that commercial banks have to maintain in cash) to inject more liquidity into the financial system. But a combination of an inflation rate that is still high and a fast depreciating Rupee against the US dollar may have forced RBI’s hand in keeping the CRR in tact. That perhaps caused disappointment that led to the sell-off today.

During a bear market, the slightest bit of ‘bad’ news causes a disproportionate amount of negative sentiment. Even if the news isn’t bad for the long-term but appears to be bad in the short-term gives a good enough reason to sell. The opposite happens in bull markets, when the slightest bit of ‘good’ news sends the stock indices soaring. That is an unlikely occurrence at least for another 6 months. Till interest rates are reduced significantly, the bulls will not return.

Related Post

Market celebrates RBI interest rate hike – why?

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