Interest rates are the compensation paid by a borrower of money to a lender of money for the use of money for a period of time. It is usually expressed in terms of percentage per annum in order to make them comparable across multiple such transactions. Interest rates can also be referred to as the cost of money or the price on money. However, in finance and in debt markets terms, we refer to interest rates as being the rates payable on debt and deposit obligations by the borrowers to the lenders. In monetary Economics the term has a special significance. In the hands of Central Banks, it is a powerful tool to balance many factors which are acting on an economy, and which if not carefully regulated would lead to disastrous consequences. In times of weak economic activity of a pessimistic business outlook or if the Unemployment rate is rising in the country, the central bank will tend to lower interest rate, which in turn will prompt commercial banks to lower their interest rates prompting businesses to borrow more with the result that business activity will rise. Similarly, when the central banks feel that there are inflationary conditions prevailing in the economy, they will increase the interest rates so that the excess purchasing power in the hands of people is curtailed leading to the softening of demand and consequently prices and with-it inflation. In fact, it is the central function of the central banks to constantly monitor the economy and use the monetary tools at its disposal to guide it in the right path.
Looking at it from a different angle, a lowering of interest rates would mean surplus funds would flow into the system and hiking of the interest rate would mean surplus funds being withdrawn from the system. This phenomenon thus has a significant effect on stock markets. Whenever there is an excess flow of funds in the economy stock markets, tend to rise, and vice versa happens when the flow of funds into the economy is curtailed. The phenomenon becomes even more significant on a global scale. Large economies like the United States of America, China and European Union when they change interest rates, have a cascading effect on the global economy, with the problem that not all such economies are controlled by the central banks of the country which is changing its interest rates. In todayâs era of the intertwined global economy, this can become dangerous. So, in effect, the practice that is taking shape is that central banks of different countries keep a keen eye on global economic parametres and the interest rate policies of key countries and appropriately adjust their own rates and that too on a dynamic basis.
It has often been observed that whenever the United Statesâ Federal Reserve increases their interest rates stock markets around the world cheer on account of surplus fund entering the markets and vice versa. In this regard for analysts, traders and market observers across the world, it becomes imperative that they study the United States Federal Reserve interest rates policies in order to guide their domestic investment strategies.
In this regard below are the five things one should be mindful about interest rates while investing in equity markets.
- Interest rate-sensitive stocks â Specifically the banking and financial services companies are susceptible to interest rate whose fortunes either rise or fall with increase or decrease of interest rates. However internationally, when funds flow across international borders investment companies are the worst affected. Other than that, travel and tourism and sectors like the one dealing with consumer durables are worst affected by interest rate hikes. It may also happen that an interest rate change may have a positive impact on a particular sector of the economy or an adverse impact on other sectors of the economy. Under such circumstances, an analyst or a trader must have a deep understanding of interest rate to navigate through the equity markets.
- Debt instrument investments â During times of stock market peaks and troughs interest rates are important factors to look out for. When stock markets are at a peak and giving high returns to investors, there is less demand for debt products, whereas when stock markets are performing poorly debt instruments could become more profitable avenues. Interest rates on debt instruments are more often than not impacted by central bank interest rates.
- Speculation activity â Lower interest regimen usually promotes the flow of excess funds into the stock markets. This situation is conducive for people to put money into stocks for speculative gains. While serious investors would put money on long term fundamental performance of a stock short speculative money tries to take advantage of stock market imperfections. This follows the common human psychology to excess funds with people than required for essential needs tend to be used into superfluous purposes. Hence it can be said with above in mind that in times of lower interest rates, there is greater speculative activity in the equity markets.
- Lag effect of interest rates â Interest rates can have an immediate impact on the stock markets, but their actual intent is to impact real economy vide conditions and the impact of the interest rate change on the economy usually comes with a lag. Hence an analyst observing the impact of interest rates would only be able to forecast the future performance of companies or sectors based on the current interest rates movement.
- The interrelation of Interest rate policy on one country with the stock market of the other â This is another unique phenomenon. It has been observed that the interest rate policy of one large country will have defined but the different impact on the stock markets of another country. This happens because of the larger country investors level of interest in investing in other countries. These patterns may change with the changing interest patterns of investors or changing economic conditions in the host country. This is a very important factor studied in capital markets, to predict FII behaviour