How Interest Rates Affect The Stock Market

By Jim Mueller on October 07, 2012 A A A

Filed Under: Capital Market, Dow Jones Industrial Average, Federal
Reserve, Inflation, Interest Rate Policy, Macroeconomics, Monetary Policy, Money Market
Interest rates. Most people pay attention to them, and they can impact the
stock market. But why? In this article, you will learn some of the indirect links
between interest rates and the stock market and how they might affect your
life.

The Interest Rate
Essentially, interest is nothing more than the cost someone pays for the use of
someone else's money. Homeowners know this scenario quite intimately. They
have to use a bank's money, through a mortgage, to purchase a home, and
they have to pay the bank for the privilege. Credit card users also know this
scenario quite well - they borrow money for the short-term in order to buy
something right away. But when it comes to the stock market and the impact of
interest rates, the term usually refers to something other than the above
examples - although we will see that they are affected as well.

The interest rate that applies to investors is the Federal Reserve's federal funds
rate. This is the cost that banks are charged for borrowing money from Federal
Reserve banks. Why is this number so important? It is the way the Federal
Reserve (the "Fed") attempts to control inflation. Inflation is caused by too
much money chasing too few goods (or too much demand for too little supply),
which causes prices to increase. By influencing the amount of money available
for purchasing goods, the Fed can control inflation. Other countries' central
banks do the same thing for the same reason.
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Basically, by increasing the federal funds rate, the Fed attempts to lower the
supply of money by making it more expensive to obtain.

Effects of an Increase
When the Fed increases the federal funds rate, itdoes not have an immediate
impact on the stock market. Instead, the increased federal funds rate has a
single direct effect - it becomes more expensive for banks to borrow money
from the Fed. Increases in the federal funds rate also cause a ripple effect,
however, and factors that influence both individuals and businesses are
affected.

The first indirect effect of an increased federal funds rate is that banks increase
the rates that they charge their customers to borrow money. Individuals are
affected through increases to credit card and mortgage interest rates, especially
if they carry a variable interest rate. This has the effect of decreasing the
amount of money consumers can spend. After all, people still have to pay the
bills, and when those bills become more expensive, households are left with less
disposable income. This means that people will spend less discretionary money,
which will affect businesses' top and bottom lines (that is, revenues and
profits).
Therefore, businesses are also indirectly affected by an increase in the federal
funds rate as a result of the actions of individual consumers. But businesses are
affected in a more direct way as well. They too borrow money from banks to run
and expand their operations. When the banks make borrowing more expensive,
companies might not borrow as much and will pay higher rates of interest on
their loans. Less business spending can slow down the growth of a company,
resulting in decreases in profit.

Stock Price Effects
Clearly, changes in the federal funds rate affect the behavior of consumers and
businesses, but the stock market is also affected. Remember that one method
of valuing a company is to take the sum of all the expected future cash
flows from that company discounted back to the present. To arrive at a stock's
price, take the sum of the future discounted cash flow and divide it by the
number of shares available. This price fluctuates as a result of the different
expectations that people have about the company at different times. Because of
those differences, they are willing to buy or sell shares at different prices.

If a company is seen as cutting back on its growth spending or is making less
profit - either through higher debt expenses or less revenue from consumers -
then the estimated amount of future cash flows will drop. All else being equal,
this will lower the price of the company's stock. If enough companies experience
declines in their stock prices, the whole market, or the indexes (like the Dow
Jones Industrial Average or the S&P 500) that many people equate with the
market, will go down.

Investment Effects
For many investors, a declining market or stock price is not a desirable
outcome. Investors wish to see their invested money increase in value. Such
gains come from stock price appreciation, the payment of dividends - or both.
With a lowered expectation in the growth and future cash flows of the company,
investors will not get as much growth from stock price appreciation, making
stock ownership less desirable.

Furthermore, investing in stocks can be viewed as too risky compared to other
investments. When the Fed raises the federal funds rate, newly offered
government securities, such Treasury bills and bonds, are often viewed as the
safest investments and will usually experience a corresponding increase in
interest rates. In other words, the "risk-free" rate of return goes up, making
these investments more desirable. When people invest in stocks, they need to
be compensated for taking on the additional risk involved in such an
investment, or a premium above the risk-free rate. The desired return for
investing in stocks is the sum of the risk-free rate and the risk premium. Of
course, different people have different risk premiums, depending on their own
tolerances for risk and the companies they are buying into. In general,
however, as the risk-free rate goes up, the total return required for investing in
stocks also increases. Therefore, if the required risk premium decreases while
the potential return remains the same or becomes lower, investors might feel
that stocks have become too risky, and will put their money elsewhere.

The Bottom Line
The interest rate, commonly bandied about by the media, has a wide and varied
impact upon the economy. When it is raised, the general effect is a lessening of
the amount of money in circulation, which works to keep inflation low. It also
makes borrowing money more expensive, which affects how consumers and
businesses spend their money; this increases expenses for companies, lowering
earnings somewhat for those with debt to pay. Finally, it tends to make the
stock market a slightly less attractive place to investment.

Keep in mind, however, that these factors and results are all interrelated. What
is described above are very broad interactions, which can play out in
innumerable ways. Interest rates are not the only determinant of stock prices
and there are many considerations that go into stock prices and the general
trend of the market - an increased interest rate is only one of them. One can
never say with confidence, therefore, that an interest rate hike by the Fed will
have an overall negative effect on stock prices.

Three critical economic
factors that influence the
Indian stock market

o
o 1 comments
+ COMMENT
VIVEK SHARMA | 27/09/2012 11:31 AM |
Different schools of thoughts have specified
different factors that make animpact on the stock
market. Among the most important are economic
policies in shaping the stock market

What makes stock market go up and down? There is no
precise answer to this question. Though fundamental
analysis and technical analysis are used to
predict market behavior and lots of research and study has
been done in this regard, stock market experts have found
it extremely difficult to fathom the reasons which cause a
change in stock market. Nassim Taleb has gone to the
extent of writing in his famous book Fooled by
Randomness that only lucky idiots make money in
the stock market thereby signifying the fact that money
made in stock market is based on not what you know but
how lucky you are.

There are different schools of thoughts which have
specified different factors that make animpact on stock
market; one common factor which often comes out from
all this analysis is the role of macro-economic factors
in shaping the stock market. How can we forget the day
when Iran threatened to close the Strait of Hormuz? The
news sent stock markets across world shaking as oil supply
was likely to get cut because of Irans move and also there
was a sudden increase in geo-political tension in the world.
Can stock marketinvestors forget the day when the UPA
(United Progressive Alliance) government came back to
power in 2009 and market got frozen on the upper circuit?
Suddenly everything stated looking hunky-dory for
the stock market because an expectation was created that
economic reforms will continue and will help stock
markets. Similarly when the government announced FDI
in retail last year, price of various stocks in retail went up
suddenly. There are several such events which prove the
fact that macro-economic factors make impact on stock
markets.

But all these factors look momentary and their impact may
not be everlasting. There are some factors which have their
long-term impact and shape the growth path of stock
market. Post 2008 the stock market in India has not seen
the best of the times and these factors are responsible to a
great extent for shaky performance of the stock market.
There are three critical macro-economic factors which
have impacted stock markets in Indiasince 2008 crisis. Let
us look at how these factors have impacted stock markets
in India.

Monetary policy and repo rate hike

Changes in the repo rate have haunted banks for quite
some time. Thirteen consecutive hikes in the repo rate
have impacted the market badly. Every time when the
Reserve Bank of India (RBI) hiked the repo
rate, market reacted negatively and went down. Only after
the pace of increase of repo rate slowed down market,
breathed a sigh of relief. In fact, such has been the impact
of the series of monetary policy measures that the stock
marketin India pays more attention to the moves of RBI
than its own regulator SEBI. The tablebelow shows the
relationship between stock market performance and repo
rate hike.

Source: www.bseindia.com (All changes in Sensex rounded
off)

As an investor, one needs to take note of this important
factor which makes an impact onstock market movement.
It is, in fact, not just the repo rate hike but the entire
monetary policy of the central bank which has a bearing on
the performance of stock market.

International crude oil price and inflation

Crude oil prices are tracked in the Indian economy with
lots of curiosity. Since India imports around 80% of crude
oil from the international market, any significant change
in price of petroleum makes an impact on inflation
numbers which in turn impacts the stock market. Inflation
numbers send the market up and down whenever they are
announced. Post 2008, there has been a consistent
inflationary pressure on the Indian economy which has
created trouble for the stock market in India. RBI data
shows that the period 1995 to 2008 was the best for the
Indian economy when inflation overall was just 5%.
Between March 2008 and January 2012, it went up and
overall inflation number touched 7.6% while primary
group had the highest inflation of 13%.


Source: RBI

Policy announcements of the government

The market, which was disappointed with the policy
paralysis of the UPA-2, got a sudden boost with hike in
diesel price and FDI in aviation and retail. The
government became the darling of the market suddenly
and it went up by close to 1,000 points within a few days.
Whether it is GAAR or power sector reforms,
the market monitors every move of the government. While
the government provides strength to the market through
regulations, it provides growth impetus with policy
announcements.

There is no denying the fact that almost every factor
having economic characteristics makes an impact on
the market but there is no denying the fact these three
factors have been a companion of the stock market for the
last five years. The performance of the stock market is
positively related to these factors. As these factors become
better, market will continue to perform better
Impact of Macroeconomic indicators on India
capital markets
By VINOD NAIR, October 22, 2012 12:14 am
Analysis of past data suggests that macroeconomic variables and the stock market index are related
and, hence, a long-run equilibrium relationship exists between them. Stock prices positively relate to
the money supply and industrial production but negatively relate to inflation.
Are stock prices influenced by macroeconomic indicators in an economy? This is an issue of interest
both to the academics as well as the practitioners all over the world. This is what researchers refer to
as the macroeconomic approach. It is a method of using factor analysis technique to determine the
factors affecting asset returns.
Many scholars have used macroeconomic factors to explain stock return and found that changes in
some macroeconomic variables are associated with risk premium. They interpreted the observations
to be a reflection of the finding that changes in the rate of inflation are fully reflected in interest rates.
The focus of the macroeconomic approach is to examine how sensitive are stock prices to changes
in macroeconomic variables. This approach maintains that the performance of stock is influenced by
changes in factors like money supply, interest rate, inflation rate, exchange rate, international crude
oil prices, external debt, and external reserve.
Several attempts have been made to identify or study the factors that affect stock prices. Some
researchers have also tried to determine the correlation between selected factors (internal and
external, market and non-market factors, economic and non-economic factors) and stock prices. The
outcomes of the studies vary depending on the scope of the study, the assets and factors examined.
The Capital Asset Pricing Model (CAPM) assumes that asset price depends only on market factor.
Hence, it is tagged a one factor model.
On the other hand the Arbitrage Pricing Technique/Model (APT) which could be taken as a protest of
CAPM believes that the asset price is influenced by both the market and non-market factors such as
foreign exchange, inflation and unemployment rates.
Let us examine the relationships between the Indian stock market index (BSE Sensex) and some
key macroeconomic variables.
Analysis of past data analysis that macroeconomic variables and the stock market index are co-
integrated and, hence, a long-run equilibrium relationship exists between them. It is observed that
the stock prices positively relate to the money supply and industrial production but negatively relate
to inflation. The exchange rate and the short-term interest rate are found to be insignificant in
determining stock prices.
Industrial Production
Index of Industrial Production (IIP) denotes the total production activity that happens in the country
during a particular period as compared to a reference period. It helps us to understand the general
level of industrial activity in the economy. The products included for calculation of IIP can be
segregated into 3 major sectors Manufacturing (79.36%), Mining & Quarrying (10.47%) and
Electricity (10.17%). Another way of categorising the items used in the calculation of IIP is a Use
based classification with categories like basic goods, capital goods, intermediate goods, consumer
durable and non-consumer durable. Now, that we know what IIP is, why is it so important?
The chart given above shows the movement of SENSEX and IIP over a four year period. It is quite
evident that the IIP and Sensex movement is closely related. The IIP data is not as volatile as the
Sensex but even a 2-3% change in IIP can lead to a lot of swing in stock market movement. There
are many other factors that impact the stock market, but IIP gives a very good indication of where it
is headed. Consider for example the period from January 2010 to April 2010. The rise in IIP during
this period has been reflected in the upward movement, which saw Sensex touching 20,000 in
September that year. Thus, IIP can drive the stock market up or down.
Gross Domestic Product
This is perhaps the most important indicator since it shows the economic progress made by the
country. Higher the GDP growth, higher would be the capital inflow into the stock markets. The year
2007, saw FII investing huge money into the Indian markets since the GDP growth was 9.2% while
the 2008 saw huge outflow since the GDP was only 6.3% even though it was far better then the
world, which grew only at 1% in 2008 during the global financial crisis.
Inflation: Two edged sword
Higher Inflation results into the higher interest rates in the economy, which makes the economy less
attractive. This results that FII sells the shares since the cost of debt goes up ad the corporate
profitability will also come down. The stock market takes the higher inflation and higher interest rates
as negative indicator and market goes down. Until recently the RBI has increased the repo rate from
3.25% to 8.25%, which had increased the cost of funds from the corporate viewpoint. This has made
the economy unattractive and stock markets displayed a negative outlook.
Fiscal Deficit
Higher fiscal deficit is also viewed as negative data from the capital market perspective and the FII
generally withdraw money from the stock markets. Higher the fiscal deficit, greater will be the
negative impact on the stock markets.
Foreign Institutional Investor Inflows
In the recent past, investments made in the Indian equity market have seen a huge surge.
Predominantly, foreign investments in India are rising. Among the investments from foreign nations,
FIIs plays a vital role in the Indian equity market as they are the main source of foreign investments
in India.
Studies of the FII flows to India and their relationship with other economic variables have arrived at
the following major conclusions:
While the flows are highly correlated with equity returns in India, they are more likely to be the effect
than the cause of these returns;
The FIIs do not seem to be at an informational disadvantage in India compared to the local
investors;
The Asian Crisis marked a regime shift in the determinants of FII flows to India with the domestic
equity returns becoming the sole driver of these flows since the crisis. Given the thinness of the
Indian market and its susceptibility to manipulations, FII flows can aggravate the equity market
bubbles, though they do not actually start them.
Conclusion
The function of stock markets in the economy is not only to raise capital but also to channel funds to
the most profitable opportunities and to ensure that those funds are well utilised. Research has
shown that inflation and foreign remittances are negatively related with stock prices indicating the
fact that additional funds flow through inflation and foreign remittances increase the supply side
through additional funds flow in the stock market while demand side remains unaffected.
Static condition in the demand side in the security market puts downward pressure in the stock price.
On the other hand positive relationship is found between stock price and the remaining independent
variables i.e. industrial production index, market price/earnings and monthly average growth rate of
market capitalisation. In general sense, growth of industrial productive activity, market p/e and
growth of market capitalisation all bear positive and favorable information content which induce the
demand side and ultimately gives positive pressure in stock price.
The author is Head-Academics & Product Development, BSE Institute Ltd.

Factors affecting the stocks
News
Impact of other asian markets
Quaterly results
Fundamental news
Inflation rate
Future/derivative expiry
Where to watch the movement of stock
View Stock Alerts
The stocks may rise or fall due to numerous reasons, some of them are mentioned below. If you at least
keep a watch on following factors. You can save yourself been big loss (if stocks are falling) or earn good
amount (if stocks are rising).

A) News
Stock market always reacts for appropriate news. Always read financial news like Business Standard and
Economics Times etc. or else watch financial news channels.

What is appropriate news?
News - Like merger announcement, this news will impact more if the merger is related to foreign
company, positive news - stocks may rise.
Demerger announcement will have negative impact - negative news - stocks may fall Merger and
Demerger announcement may have major impact on Indian Stock Market.
Acquisition (takeover) Announcement - Takeover of some part (or whole) of companies, especially
those having larger capacity/turnover or foreign companys. This news will have major impact on that
particular stock - very positive news - stocks may rise, dont miss this opportunity. Buy stocks of such
companies. Takeover may have positive impact on Indian Stocks.

Expansion Plan - Announcement like major expansion plan of a company or entering into other sectors
or opening new plants, branches, turnover increase announcement, new product launch etc.
Above announcement will have a positive impact on a stock market - stock may rise.

Political News - News like elections in the country or in any particular state, news of any major change
in political upfront or in any change in rules will also have major impact on Indian stock market.
Political news related to any particular State will have major impact on companies located in that state for
example major Sugar Companies are located at Uttar Pradesh like Balrampur Chinni, Triveni Engg, Bajaj
Hindustan etc. so any major political news especially related to any sector will have major impact on
stocks of that sector.

Sector News - The stocks of Indian stock market have different sectors and if any announcement of
news by Government for any particular sector will have major impact on stocks of that sector.
Following are few sectors, few companies and few related news that may affect stock prices in Indian
Stock Market
Sector Companies News Announcement
Banking - ICICI, SBI, UTI, Indian Bank etcHike or decrease in interest rates, loan rates etc.
Oil - IPCL, BPCL etcHike or decrease in diesel prices, hike or decrease in crude oil prices etc.
Retail - Dabur, ITC, etc News related to any taxes etc.
Cement - Indian Cement, Gujambcem etc Hike or decrease in cement prices.
In short sector news will affect stocks from that sector

B) Impact of Other Asian Market
Most of the time it has been observed and studied that Indian Market (Nifty/Sensex) follows other Asian
markets and USA markets.
Asian markets like China - Shanghais market, Japan - Nikkei market, Hong Kong - Hang Sung market.
Above all Asian markets open early than Indian market. Most of the time Indian market will follow this
Asian markets.
If these Asian markets open in positive and lead to positive direction than the Indian markets will react in
the same manner and vice-versa provided that there is no major news in India.
USA market - USA markets like NASDAQ and DOW will also have major impact on Indian market.
So, in short in the morning around 9.30 am (Indian market opens at 9.30 am) get all news above USA
markets (which opens and closes in our night time which is their day time) and Asian markets and plan
yours day trading.
Individual stock - If the stock is over bought, then some profit taking will takes place ( price may come
down) and if stock is over sold then you may see some buying (price may go up) of those stocks with
large volumes, than you can plan your trades accordingly
C) Quarterly Results - (Very important)
Quarterly results declared by all Indian Companies will have major impact on that company and hence
their stocks in Indian stock market. Every company declares its quarterly results. If any company declares
extra-ordinary results that will definitely affects its stocks. Most of all stock traders concentrate on much
profit and target sales that company had made. If company achieved good profit than they declare
dividend, bonus stocks etc. This will make positive impact on stocks of that company
D) Fundamental News
Fundamental news means companies own news. Companies own news means future turnover
announcements, any change in director body, future releases etc. If the company has good fundamentals
like board of directors, companies expansion plans, future acquisition etc then its worth to invest in such
companies for long term.


E) Inflation Rate - (Very important)
Inflation rate is wholesale prices of consumer goods. This rate is declared by Government for every week
at Friday (weekend) 12.00 pm. The inflation rate indicates what the wholesale price was for that week. If it
is low
As compared to previous week, then it is positive news and you may see stock prices going up and if the
rate is higher as compared to previous week, then it is negative and this may affect stock prices
negatively and stock prices may come down.
So keep a watch. Inflation rate declare by Indian Government at every Friday 12.00 pm and trade
accordingly.
Indian stock market reacts to inflation rate.


F) Future/Derivative Expiry - (Very important)
Future/Derivatives has expiry period of one month. Derivatives get expired on last Thursday of a month.
Future/Derivative gets expired means you have to sell your future/derivatives which you carry for whole
month and buy for next month. Due to this expiry period stock traders sell there derivatives, due to which
stocks prices may come down.
If you watch the stock market carefully this selling movement starts before one or two days of expiry. So
be cautious and plan your trade accordingly.
During this expiry period you may see stocks prices coming down then you can plan your buying and
selling in next month when prices go up.


G) Where to Keep Watch - (for day traders)
Keep a close watch on stocks which comes under top gainers, top losers and which are touching all time
high. What can be done in after market hours (when market closes at 3.30 pm) you can make a list of all
those stocks then plan your trade.
Touching all time high is positive news.