Be a Prudent Investor by Keeping an Eye on Interest Rates

The first thing that strikes our mind when we go for that big ticket purchase is of course the interest rate on the loan lent by banks or financial institutions. Higher interest rates translate into higher Equated Monthly Installments (EMIs), tighter monthly budgets and lower savings. It just explains why the interest rate is more prominently displayed in brochures screaming out new loan schemes launched by banks and financial institutions.

So it’s obvious that lower interest rates enable individuals to save more and invest in financial instruments of their choice. Well, now how many times do we go for big ticket purchases? At the most a house or two or a couple of cars in one’s lifetime (if we exclude the High Net Worth Individuals). So do we really have to constantly track interest rates? A discerning investor in all probability will do that. Let me tell you why.

Interest rate is a key weapon used by the American Federal Reserve (the Fed) and other similar central banks around the world such as the Reserve Bank of India for controlling inflation. During periods of high inflation, central banks increase repo rates (the rate at which central banks lend money to retail banks) to curtail borrowing. The retail banks in turn pass over the higher interest rates to individual customers and companies by increasing interest rates on home loans, car loans, business loans and credit cards among others. With the increase in value of currency, people and companies curb their expenditure, which in turn translates into lower demand and softening of inflation. The positive side to this increase is that banks and governments increase the interest rate on deposits and bonds (read national savings certificate). So, it’s good news for depositors.   

Effect on Companies and Stock Markets

As interest rates increase, the valuations of companies fall as companies find it harder to borrow money, expand their operations and increase profits. And with the parallel increase in fixed deposit rates and bond rates, the stock market naturally becomes less lucrative for investors who then generally opt for the much safer debt instruments (such as fixed deposits and bonds) over the stock markets. This in turn leads to less cash flow in the stock markets and lower returns from them.

However, interest rate is only one of the many factors that influence the stock market and one cannot for sure say that a rise in interest rate will negatively impact the stock markets.