1. If rates go up, Fixed Income starts to look attractive,
- Example: Let’s say you have $10,000 to invest. If you invest in a savings account with an interest rate of 1%, you will earn $100 in interest over a year. However, if you invest in a bond with a 5% yield, you will earn $500 in interest over a year. When fixed income investments like bonds offer higher yields, they become more attractive to investors, which can lead them to move money out of the equity market and into bonds.
2. In a rising rate environment, $ becomes stronger because rising rate is a sign of the economy doing well,
- Example: Imagine you are a foreign investor who wants to invest in the Indian stock market. You convert your dollars to rupees to buy stocks in India. But if the rupee depreciates against the dollar, your returns will be lower even if the Indian stocks do well. This makes it less attractive for foreign investors to invest in Indian equities when the dollar is strong.
3. Liquidity starts flowing to fixed income assets,
- Example: Let’s say a mutual fund has a lot of money to invest. If the fixed income market is offering higher yields, the mutual fund manager may decide to allocate more of the fund’s money to fixed income investments like bonds rather than stocks. This can lead to less money flowing into the equity market, which can cause stock prices to fall.
4. Rates going up can also end up hurting demand assuming everything else is constant,
- Example: Higher interest rates mean that borrowing money becomes more expensive. If people and businesses have to pay more to borrow money, they may be less likely to take out loans. For example, higher interest rates on home loans can make it more difficult for people to buy houses, which can reduce demand for homes and impact the performance of the real estate sector.
5. Increasing rates can also reduce corporate profits,
- Example: When interest rates rise, it becomes more expensive for companies to borrow money. This can lead to higher interest expenses for companies that have a lot of debt, which can eat into their profits. This can impact the performance of the stock market if investors become less optimistic about the earnings potential of these companies.
6. Rising rates also hurt valuations,
- Example: When investors value a company using the discounted cash flow (DCF) method, they discount expected future cash flows to the present using a discount rate. A higher discount rate (such as a higher interest rate) means that future cash flows are worth less today, which can lead to a lower valuation for the company. This can impact the performance of the stock market if investors become less optimistic about the future earnings potential of companies.
These conditions are more prevalent in emerging markets like India. However, it’s important to note that rising rates don’t always mean that stock prices will go down. In fact, often times, rates and stock prices rise at the same time. So while some parts of the stock market may do better than others in a rising rate environment, it doesn’t necessarily mean that the stock market as a whole will go down.
But in some scenarios, market can also go up along with rising interest rate as there could be sector wise up movements. When interest rates change, it affects which types of companies investors want to invest in. Companies that are considered safe and pay dividends (like FMCG and utilities) tend to do poorly when rates go up. On the other hand, companies like banks tend to do well because higher rates can mean the economy is doing better.
