Low Interest Rates Driving To Equities

The stock markets and the investor community give a great deal of importance to the Monetary Policy Committee (MPC) meeting that the Reserve Bank of India (RBI) holds every quarter. This is primarily because the MPC meeting is when the repo rates are decided and announced by the central bank. The repo rate is essentially the rate of interest at which commercial banks borrow from the Reserve Bank of India.

Any change in this repo rate is likely to have an impact on the savings and the borrowing costs of individuals and institutions alike. Since the interest rate announcements have such a huge impact on the financial sector of the nation, it is natural for the stock market to react to any change in the rates. But before we try to understand why low interest rates are driving people to buy shares online, it is essential for us to understand the relationship between the stock markets and interest rates.

The relationship between the stock markets and the interest rates
The stock markets and the interest rates share a unique, inverse relationship with each other. What this effectively means is that when the interest rates are reduced, the stock market tends to see a rise in the online trading participation levels. This increase is almost always likely to push the prices of stocks up.

Similarly, when the interest rates increase, equities usually witness a fall in the online trading participation levels. This occurs as a result of investors moving out of the stock markets. Such a decrease would almost always end up driving the prices of stocks down. Here’s a great chart that clearly outlines the inverse relationship between the stock markets and the interest rates.

(Source: Forbes)

In this chart, the red line represents the S&P 500’s P/E ratio, which acts as a good indicator of the U.S. stock market movement. The black line represents the interest rates of the U.S. As you can see here, when the interest rates are kept low, the stock market experiences a rise. As the interest rates slowly start to rise, the stock markets experience a dip, with fewer people willing to buy shares online. And again, when the interest rates are reduced, the stock market bounces back up.

Although this chart is a representation of the United States’ stock market movement, the inverse relationship holds true even with respect to the Indian markets and the global markets as well.

Why are lower interest rates driving people to equities?
Now that you’ve properly understood the relationship, let’s try to understand the reasoning behind lower interest rates driving higher online trading participation.

Whenever the repo rates are decreased by the RBI in its MPC meeting, borrowing funds get cheaper. And as a result, the interest rates of loans and mortgages would also get lower. This would increase the flow of money into the economy significantly. In addition to this, a decrease in the repo rate would also decrease the interest rates of several fixed-income savings schemes like fixed deposits, among others. Such a situation has a two-pronged effect on the stock markets.

Firstly, due to the fall in the interest rates, companies would end up paying less interest on their loans. As a result, their finance costs would likely see a significant fall. This decrease in the finance costs of companies would ultimately lead to a rise in their profits, thereby making them very attractive investment opportunities. Investors generally tend to gravitate towards such companies, thereby promoting a rise in the stock market prices.

And secondly, when the interest rates fall, the yields of fixed-income investments are also likely to decrease. This would decrease the return on investment (ROI) of investors. And so, investors would typically try to switch to the considerably more riskier equity market in search for better returns. Such a move would invariably be the cause of a rise in the online trading participation and ultimately higher stock market prices.

All things considered, the present economic scenario is going through a turbulent phase due to the ongoing COVID-19 pandemic. Low economic growth has resulted in many fixed-income investment options taking a huge hit. The returns offered by these investments may be low and unattractive for investors. The repo rate cut by the RBI in the month of March, 2020 has ended up reducing the already low bank interest rates even further.

This has encouraged many investors, some of whom are even risk-averse, to move towards the equity markets in the hopes of earning better returns. The recent influx of retail investors in the stock market looking to buy shares online is a testament to the fact that low interest rates are the driving force behind greater equity participation.