Interest rates have a deep relationship with stock markets and are one of the major factors in determining market direction and trajectory. Since it is basically the cost of money, it affects the entire financial system. Lower interest rates encourage people to borrow and spend which helps the economy. Likewise businesses also benefit from access to cheaper funds to invest and grow the business. However cheap funds can also lead to inflation and loss of purchasing power so it is a delicate balancing act that every government aspires to accomplish. And then there are other related and dynamic factors like currency, CAD and growth issues which have to be taken into account before arriving on the correct number for that brief period.
Currently India seems to have painted itself into a corner. But before we raise a finger at our situation, keep in mind that in 1981–82 the inflation in the US was 14% and Fed interest rates were about 20%.Within 20 years the rate fell to 1.25% due to a combination of good economy management and a favourable global environment combined with long-term vision. So there’s reason to believe that pragmatism and actions towards our long-term goals may yet guide us towards our economic objectives.
The primary reason why the RBI changes interest rates is to influence the amount of money in the system and therefore control inflation. So will the equity markets discount the RBI’s latest stance on interest rates very strongly? Well, after the strong reversal by the dollar the RBI surprised the markets by raising its key lending rate by a quarter of a percentage point which clearly shows that inflation continues to be priority number one and growth is number three—assuming that a stable currency is a more immediate requirement. While the RBI has the unenviable job of controlling these three together, the markets, unsurprisingly, reacted strongly and immediately reversed the gains accumulated after the US Fed’s surprisingly unchanged stance on quantitative easing. Stocks from interest rate sensitive sectors fell sharply and bond yields, which move in an opposite direction to prices, rose sharply as this was taken as a signal that money will not become cheap in a hurry. In several trading sessions after the announcement, the Nifty shed more than 5% but this news has now been discounted and there is consolidation at lower levels. Unless there is more news on this or any other